## 9.1 – A note on Financial Ratios

Over the last few chapters we have understood how to read the financial statements. We will now focus our attention on analyzing these financial statements. The best way to analyze the financial statements is by studying the ‘Financial Ratios’. The theory of financial ratios was made popular by Benjamin Graham, who is popularly known as the father of fundamental analysis. Financial ratios help in interpreting the results, and allows comparison with previous years and other companies in the same industry.

A typical financial ratio utilizes data from the financial statement to compute its value. Before we start understanding the financial ratios, we need to be aware of certain attributes of the financial ratios.

On its own merit, the financial ratio of a company conveys very little information. For instance, assume Ultratech Cements Limited has a profit margin of 15%, how useful do you think this information is? Well, not much really. 15% profit margin is good, but how would I know if it is the best?

However, assume you figure out ACC Cement’s profit margin is 12%. Now, as we comparing two similar companies, comparing the profitability makes sense. Clearly, Ultratech Cements Limited seems to be a more profitable company between the two. The point that I am trying to drive across is that more often than not, Financial Ratios on its own is quite mute. The ratio makes sense only when you compare the ratio with another company of a similar size or when you look into the trend of the financial ratio. This means that once the ratio is computed the ratio has to be analyzed (either by comparison or tracking the ratio’s historical trend) to get the best possible inference.

Also, here is something that you need to be aware off while computing ratios. Accounting policies may vary across companies and across different financial years. A fundamental analyst should be cognizant of this fact and should adjust the data accordingly, before computing the financial ratio.

## 9.2 – The Financial Ratios

Financial ratios can be ‘somewhat loosely’ classified into different categories, namely –

- Profitability Ratios
- Leverage Ratios
- Valuation Ratios
- Operating Ratios

**The Profitability ratios** help the analyst measure the profitability of the company. The ratios convey how well the company is able to perform in terms of generating profits. Profitability of a company also signals the competitiveness of the management. As the profits are needed for business expansion and to pay dividends to its shareholders a company’s profitability is an important consideration for the shareholders.

**The Leverage ratios** also referred to as solvency ratios/ gearing ratios measures the company’s ability (in the long term) to sustain its day to day operations. Leverage ratios measure the extent to which the company uses the debt to finance growth. Remember for the company to sustain its operations, it has to pay its bills and obligations. Solvency ratios help us understand the company’s long term sustainability, keeping its obligation in perspective.

**The Valuation ratios** compare the stock price of the company with either the profitability of the company or the overall value of company to get a sense of how cheap or expensive the stock is trading. Thus this ratio helps us in analysing whether the current share price of the company is perceived as high or low. In simpler words, the valuation ratio compares the cost of a security with the perks of owning the stock.

**The Operating Ratios**, also called the ‘Activity Ratios’ measures the efficiency at which a business can convert its assets (both current and noncurrent) into revenues. This ratio helps us understand how efficient the management of the company is. For this reason, Operating Ratios are sometimes called the ‘Management Ratios’.

Strictly speaking, ratios (irrespective of the category it belongs to) convey a certain message, usually related to the financial position of the company. For example, ‘Profitability Ratio’ can convey the efficiency of the company, which is usually measured by computing the ‘Operating Ratio’. Because of such overlaps, it is difficult to classify these ratios. Hence the ratios are ‘somewhat loosely’ classified.

## 9.3 – The Profitability Ratios

We will look into the following ratios under ‘The Profitability Ratio’:

- EBITDA Margin (Operating Profit Margin)
- EBITDA Growth (CAGR)

- PAT Margin
- PAT Growth (CAGR)

- Return on Equity (ROE)
- Return on Asset (ROA)
- Return on Capital Employed (ROCE)

**EBITDA Margin:**

**The Earnings before Interest Tax Depreciation & Amortization (EBITDA) Margin** indicates the efficiency of the management. It tells us how efficient the company’s operating model is. EBITDA Margin tells us how profitable (in percentage terms) the company is at an operating level. It always makes sense to compare the EBITDA margin of the company versus its competitor to get a sense of the management’s efficiency in terms of managing their expense.

In order to calculate the EBITDA Margin, we first need to calculate the EBITDA itself.

**EBITDA = [Operating Revenues – Operating Expense**]

Operating Revenues = [Total Revenue – Other Income]

Operating Expense = [Total Expense – Finance Cost – Depreciation & Amortization]

**EBIDTA Margin = EBITDA / [Total Revenue – Other Income]**

Continuing the example of Amara Raja Batteries Limited, the EBITDA Margin calculation for the FY14 is as follows:

We first calculate EBITDA , which is computed as follows:

[Total Revenue – Other Income] – [Total Expense – Finance Cost – Depreciation & Amortization]

Note: Other income is income by virtue of investments and other non operational activity. Including other income in EBITDA calculation would clearly skew the data. For this reason, we have to exclude Other Income from Total Revenues.

[3482 – 46] – [2942 – 0.7 – 65]

= [3436] – [2876]

**= 560 Crores**

Hence the EBITDA Margin is:

560 / 3436

**= 16.3%**

I have two questions for you at this stage:

- What does an EBITDA of Rs.560 Crs and an EBITDA margin of 16.3% indicate?
- How good or bad an EBITDA margin of 16.3% is?

The first question is a fairly simple. An EBITDA of Rs.560 Crs means that the company has retained Rs.560 Crs from its operating revenue of Rs.3436 Crs. This also means out of Rs.3436 Crs the company spent Rs.2876 Crs towards its expenses. In percentage terms, the company spent 83.7% of its revenue towards its expenses and retained 16.3% of the revenue at the operating level, for its operations.

Now for the 2^{nd} question, hopefully you should **not** have an answer.

Remember we did discuss this point earlier in this chapter. A financial ratio on its own conveys very little information. To make sense of it, we should either see the trend or compare it with its peers. Going with this, a 16.3% EBITDA margin conveys very little information.

To makes some sense of the EBITDA margin, let us look at Amara Raja’s EBITDA margin trend for the last 4 years, (all numbers in Rs Crs, except EBITDA margin):

Year | Operating Revenues | Operating Expense | EBITDA | EBITDA Margin |
---|---|---|---|---|

2011 | 1761 | 1504 | 257 | 14.6% |

2012 | 2364 | 2025 | 340 | 14.4% |

2013 | 2959 | 2508 | 451 | 15.2% |

2014 | 3437 | 2876 | 560 | 16.3% |

It appears that ARBL has maintained its EBITDA at an average of 15%, and in fact on a closer look it is clear the EBITDA margin is increasing. This is a good sign as it shows consistency and efficiency in the management’s operational capabilities.

In 2011 the EBITDA was Rs.257 Crs and in 2014 the EBITDA is Rs.560Crs. This translates to a 4 year **EBITDA CAGR growth** of 21%.

Please note, we have discussed the formula for CAGR in module 1.

Clearly, it appears that both EBITDA margin and EBITDA growth are quite impressive. However we still do not know if it is the best. In order to find out if it is the best one needs to compare these numbers with its competitors. In case of ARBL it would be Exide batteries Limited. I would encourage you to do the same for Exide and compare the results.

**PAT Margin:**

While the EBITDA margin is calculated at the operating level, the Profit After Tax (PAT) margin is calculated at the final profitability level. At the operating level we consider only the operating expenses however there are other expenses such as depreciation and finance costs which are not considered. Along with these expenses there are tax expenses as well. When we calculate the PAT margin, all expenses are deducted from the Total Revenues of the company to identify the overall profitability of the company.

**PAT Margin = [PAT/Total Revenues]**

PAT is explicitly stated in the Annual Report. ARBL’s PAT for the FY14 is Rs.367 Crs on the overall revenue of Rs.3482 Crs (including other income). This translates to a PAT margin of:

= 367 / 3482

=10.5 %

Here is the PAT and PAT margin trend for ARBL:

Year | PAT (in INR Crs) | PAT Margin |
---|---|---|

2011 | 148 | 8.4% |

2012 | 215 | 8.9% |

2013 | 287 | 9.6% |

2014 | 367 | 10.5% |

The PAT and PAT margin trend seems impressive as we can clearly see a margin expansion. The 4 year CAGR growth stands at 25.48%, which is again good. Needless to say, it always makes sense to compare ratios with its competitors.

**Return on Equity (RoE):**

The Return on Equity (RoE) is a very important ratio, as it helps the investor assess the return the shareholder earns for every unit of capital invested. RoE measures the entity’s ability to generate profits from the shareholders investments. In other words, RoE shows the efficiency of the company in terms of generating profits to its shareholders. Obviously, higher the RoE, the better it is for the shareholders. In fact this is one of the key ratios that helps the investor identify investable attributes of the company. To give you a perspective, the average RoE of top Indian companies vary between 14 – 16%. I personally prefer to invest in companies that have a RoE of 18% upwards.

This ratio is compared with the other companies in the same industry and is also observed over time.

Also note, if the RoE is high, it means a good amount of cash is being generated by the company, hence the need for external funds is less. Thus a higher ROE indicates a higher level of management performance.

**RoE can be calculated as: [Net Profit / Shareholders Equity* 100]**

There is no doubt that RoE is an important ratio to calculate, but like any other financial ratios it also has a few drawbacks. To help you understand its drawbacks, consider this hypothetical example.

Assume Vishal runs a Pizza store. To bake pizza’s Vishal needs an oven which costs him Rs.10,000/-. Oven is an asset to Vishal’s business. He procures the oven from his own funds and seeks no external debt. At this stage you would agree on his balance sheet he has a shareholder equity of Rs.10,000 and an asset equivalent to Rs.10,000.

Now, assume in his first year of operation, Vishal generates a profit of Rs.2500/-. What is his RoE? This is quite simple to compute:

RoE = 2500/10000*100

=25.0%.

Now let us twist the story a bit. Vishal has only Rs.8000/- he borrows Rs.2000 from his father to purchase an oven worth Rs.10000/-. How do you think his balance sheet would look?

On the liability side he would have:

Shareholder Equity = Rs.8000

Debt = Rs.2000

This makes Vishal’s total liability Rs. 10,000. Balancing this on the asset side, he has an asset worth Rs.10,000. Let us see how his RoE looks now:

RoE = 2500 / 8000*100

= 31.25%

With an additional debt, the RoE shot up quite significantly. Now, what if Vishal had only Rs.5000 and borrowed the additional Rs.5000 from his father to buy the oven. His balance sheet would look like this:

On the liability side he would have:

Shareholder Equity = Rs.5000

Debt = Rs.5000

Vishal’s total liability is Rs. 10,000. Balancing this on the asset side, he has an asset worth Rs.10,000. Let us see how his RoE looks now:

RoE = 2500 / 5000 *100

=50.0%

Clearly, higher the debt Vishal seeks to finance his asset, (which in turn is required to generate profits) higher is the RoE. A high RoE is great, but certainly not at the cost of high debt. The problem is with a high amount of debt, running the business gets very risky as the finance cost increases drastically. For this reason inspecting the RoE closely becomes extremely important. One way to do this is by implementing a technique called the **‘DuPont Model’ also called DuPont Identity.**

This model was developed in 1920’s by the DuPont Corporation. DuPont Model breaks up the RoE formula into three components with each part representing a certain aspect of business. The DuPont analysis uses both the P&L statement and the Balance sheet for the computation.

The RoE as per DuPont model can be calculated as:

If you notice the above formula, the denominator and the numerator cancels out with one another eventually leaving us with the original RoE formula which is:

**RoE = Net Profit / Shareholder Equity *100**

However in the process of decomposing the RoE formula, we gained insights into three distinct aspects of the business. Let us look into the three components of the DuPont model that makes up the RoE formula :

**Net Profit Margin = Net Profits/ Net Sales*100**

This is the first part of the DuPont Model and it expresses the company’s ability to generate profits. This is nothing but the PAT margin we looked at earlier in this chapter. A low Net profit margin would indicate higher costs and increased competition.**Asset Turnover = Net Sales / Average Total asset**

Asset turnover ratio is an efficiency ratio that indicates how efficiently the company is using its assets to generate revenue. Higher the ratio, it means the company is using its assets more efficiently. Lower the ratio, it could indicate management or production problems. The resulting figure is expressed as number of times per year.**Financial Leverage = Average Total Assets / Shareholders Equity**

Financial leverage helps us answer this question – ‘For every unit of shareholders equity, how many units of assets does the company have’. For example if the financial leverage is 4, this means for every Rs.1 of equity, the company supports Rs.4 worth of assets. Higher the financial leverage along with increased amounts of debt, will indicate the company is highly leveraged and hence the investor should exercise caution. The resulting figure is expressed as number of times per year.

As you can see, the DuPont model breaks up the RoE formula into three distinct components, with each component giving an insight into the company’s operating and financial capabilities.

Let us now proceed to implement the DuPont Model to calculate Amara Raja’s RoE for the FY 14. For this we need to calculate the values of the individual components.

**Net Profit Margin**: As I mentioned earlier, this is same as the PAT margin. From our calculation earlier, we know the Net Profit Margin for ARBL is **9.2%**

**Asset Turnover = Net Sales / Average Total assets**

We know from the FY14 Annual Report, Net sales of ARBL stands at Rs.3437 Crs.

The denominator has Average Total Assets which we know can be sourced from the Balance Sheet. But what does the word ‘Average’ indicate?

From ARBL’s balance sheet, the total asset for FY14 is Rs.2139Crs. But think about this, the reported number is for the Financial Year 2014, which starts from 1^{st} of April 2013 and close on 31^{st} March 2014. This implies that at the start of the financial year 2014 (1^{st} April 2013), the company must have commenced its operation with assets that it carried forward from the previous financial year (FY 2013). During the financial year (FY 2014) the company has acquired some more assets which when added to the previous year’s (FY2013) assets totaled to Rs.2139 Crs. Clearly the company started the financial year with a certain rupee value of assets but closed the year with a totally different rupee value of assets.

Keeping this in perspective, if I were to calculate the asset turnover ratio, which asset value should I consider for the denominator? Should I consider the asset value at the beginning of the year or at the asset value at the end of the year? To avoid confusion, the practice is to take average of the asset values for the two financial years.

Do remember this technique of averaging line items, as we will be using this across other ratios as well.

From ARBL’s annual report we know:

Net Sales in FY14 is Rs.3437Crs

Total Assets in FY13 is Rs.1770 Crs

Total Assets in FY14 is Rs.2139 Crs

Average Assets = (1770 + 2139) / 2

= 1955

Asset Turnover = 3437 / 1955

= **1.75 times**

This means for every Rs.1 of asset deployed, the company is generating Rs.1.75 in revenues.

We will now calculate the last component that is the Financial Leverage.

**Financial Leverage = Average Total Assets / Average Shareholders Equity**

We know the average total assets is Rs.1955. We just need to look into the shareholders equity. For reasons similar to taking the “Average Assets” as opposed to just the current year assets, we will consider “Average Shareholder equity” as opposed to just the current year’s shareholder equity.

Shareholders Equity for FY13 = Rs.1059 Crs

Shareholders Equity for FY14 = Rs.1362 Crs

Average shareholder equity = Rs.1211 Crs

Financial Leverage = 1955 / 1211

= **1.61 times**

Considering ARBL has little debt, Financial Leverage of 1.61 is indeed an encouraging number. The number above indicates that for every Rs.1 of Equity, ARBL supports Rs.1.61 of assets.

We now have all the inputs to calculate RoE for ARBL, we will now proceed to do the same:

**RoE = Net Profit Margin X Asset Turnover X Financial Leverage**

= 9.2% * 1.75 * 1.61

**~ 25.9%. **Quite impressive I must say!

I understand this is a lengthy way to calculate RoE, but this is perhaps the best way as in the process of calculating RoE, we can develop valuable insights into the business. DuPont model not only answers what the return is but also the quality of the return.

However if you wish do a quick RoE calculation you can do so the following way:

**RoE = Net Profits / Avg shareholders Equity**

From the annual report we know for the FY14 the PAT is Rs.367 Crs

RoE = 367 / 1211

**= 30.31%**

**Return on Asset (RoA):**

Having understood the DuPont Model, understanding the next two ratios should be simple. Return on Assets (RoA) evaluates the effectiveness of the entity’s ability to use the assets to create profits. A well managed entity limits investments in non productive assets. Hence RoA indicates the management’s efficiency at deploying its assets. Needless to say, higher the RoA, the better it is.

**RoA = [Net income + interest*(1-tax rate)] / Total Average Assets**

From the Annual Report, we know:

Net income for FY 14 = Rs.367.4 Crs

And we know from the Dupont Model the Total average assets (for FY13 and FY14) = Rs.1955 Crs

So what does **interest *(1- tax rate)** mean? Well, think about it, the loan taken by the company is also used to finance the assets which in turn is used to generate profits. So in a sense, the debtholders (entities who have given loan to the company) are also a part of the company. From this perspective the interest paid out also belongs to a stakeholder of the company. Also, the company benefits in terms of paying lesser taxes when interest is paid out, this is called a ‘tax shield’. For these reasons, we need to add interest (by accounting for the tax shield) while calculating the ROA.

The Interest amount (finance cost) is Rs.7 Crs, accounting for the tax shield it would be

= 7* (1 – 32%)

= 4.76 Crs . Please note, 32% is the average tax rate.

Hence ROA would be –

RoA = [367.4 + 4.76] / 1955

~ 372.16 / 1955

**~19.03% **

**Return on Capital Employed (ROCE):**

The Return on Capital employed indicates the profitability of the company taking into consideration the overall capital it employs.

Overall capital includes both equity and debt (both long term and short term).

**ROCE = [Profit before Interest & Taxes / Overall Capital Employed]**

Overall Capital Employed = Short term Debt + Long term Debt + Equity

From ARBL’s Annual Report we know:

Profit before Interest & Taxes = Rs.537.7 Crs

Overall Capital Employed:

Short term debt: Rs.8.3 Crs

Long term borrowing: Rs.75.9 Crs

Shareholders equity = Rs.1362 Crs

Overall capital employed: 8.3 + 75.9 + 1362 = 1446.2 Crs

ROCE = 537.7 / 1446.2

**= 37.18%**

### Key takeaways from this chapter:

- A Financial ratio is a useful financial metric of a company. On its own merit the ratio conveys very little information
- It is best to study the ratio’s recent trend or compare it with the company’s peers to develop an opinion
- Financial ratios can be categorized into ‘Profitability’, ‘Leverage’, ‘Valuation’, and ‘Operating’ ratios. Each of these categories give the analyst a certain view on the company’s business
- EBITDA is the amount of money the company makes after subtracting the operational expenses of the company from its operating revenue
- EBITDA margin indicates the percentage profitability of the company at the operating level
- PAT margin gives the overall profitability of the firm
- Return on Equity (ROE) is a very valuable ratio. It indicates how much return the shareholders are making over their initial investment in the company
- A high ROE and a high debt is not a great sign
- DuPont Model helps in decomposing the ROE into different parts, with each part throwing light on different aspects of the business
- DuPont method is probably the best way to calculate the ROE of a firm
- Return on Assets in an indicator of how efficiently the company is utilizing its assets
- Return on Capital employed indicates the overall return the company generates considering both the equity and debt.
- For the ratios to be useful, it should be analyzed in comparison with other companies in the same industry.
- Also, ratios should be analyzed both at a single point in time and as an indicator of broader trends over time

In ROA how did you get 496 as Net income before interest & taxes. As per AR isnt it 541-1-65=475, where 541 is Profit before Tax, 1 is finance cost and 65 is depreciation.

Amit, thanks so much for pointing this out. In fact the formula should be ROA = [Net Income + Interest*(1-tax rate)] / Avg Asset. ROA calculates the return with respect to the average assets that the company holds. We add back interest because the interest is paid out to the debt holders who in turn has financed to company. And when we pay out interest, lesser taxes are paid, hence the company gets a tax shield. This is the reason why we have interest*(1-tax rate).

Your Opinion is also correct. But I feel Return on Assets Formula should be

Net Income/ Total Assets (or Avg Assets). Interest Should not be added back as we are calculation is made for Equity Holders.

Instead of “we are” read “our”

I guess you are saying that since the interest is paid to debt holders and that money actually belongs to them.

The PAT for 2014 was 367 crores while you show it as 322 Crores ( Have you deducted something from PAT?)

Karthik Ji , COnfused about this PAT, can you clarify?

Profit After Taxes (PAT) is the final amount that the company retains after accounting for its expenses, deprecation, and taxes.

Yes, but the ARBL annual report explicitly states PAT = 367.4 crores, as pointed out by Chetan. So, why are we using the number the number 322 instead?

Let me recheck this…while writing this chapter I put down all the numbers on excel…hope I’ve not made silly typos while doing this 🙁

While calculating the ROA, you said the formula is RoA = [Net income before + interest*(1-tax rate)] / Total Average Assets

The Total Avg Assets is 1955, But seems like you have picked Avg shareholders equity which is 1211 .

Thanks for pointing this, I will make the correction.

Karthik Sir… Was going through the VST trillers AR, They have Öther Long Term Liabilities”under liablities ( Balance Sheet), Referring the Note it was the Rental and dealer deposits which VST has received and offcourse they should repay it at the time of Contract termination/expiration. How do we treat this? I guess VST will use this for investment or as deposits which will fetch them Interest.

How and where should we account this?

So parts of “Other Long Term Liabilities” will be be balanced out in the cash or investments – which is the asset side of the balance sheet. And the interest income received from such investments (if any) will be included in ‘Other Income” of the P&L statement.

kARTHIK,

While computing ROCE above, how did you take the fig. of NPBIT as 496 Cr.? Whereas ideally it should be 540 Cr. Isn’t it? Pls clarify.

Karthik,

Sorry, You r right.

🙂

In Calculation of ROE for Vishal Pizza store you have not deducted interest from Profits and hence its conceptually wrong. please correct the same

Thanks for pointing this Abhishek, the point was to take a bare bone example to illustrate how ROE can get skewed with the presence of debt. Also, when you do this excersie on a real company you would divide PAT by Equity…PAT anyway deducts the finance cost.

Why can’t we take ROCE as a measure to gauge company’s performance as it includes both debt and equity? If ROCE is good then ROE will definitely be good. Can you please clarify?

Well you can do that, but the beauty of ROE is that it allows you to break up and analyse the company in many different aspects – leverage, sales, assets etc..thereby giving you a better insight into company’s operations.

Sir,

While calculating ROA, from where you got this figure i. e 0.4738.

[RoA = [367.4 + 0.4738] / 1955]

Thank you.

Raju – When calculating ROA we need to account for the tax shield.

The Interest amount (finance cost) is Rs.1 Crs, accounting for the tax shield it would be

= 1* (1 – 34%)

= 0.4738 Crs .

Do note, 34% is the average tax rate.

Sir, i dont know how to download fundamental analysis Part 2… I want to learn financial ratios.. help me plz.

The PDF is available at the end of the module page here – https://zerodha.com/varsity/module/fundamental-analysis/

Sir,

Instead of 0.4738, I get the answer 0.66% when I enter this formula “= 1* (1 – 34%)” into the excel sheet.

Please explain in detail.

Thank you.

Guess you could be right here, let me recheck and correct the typo if required. Thanks for pointing this.

Thank you for pointing out the error. Yes it should have been 0.66 crores, we have made the necessary correction.

I think the above calculation should be 0.7*(1-32%)=0.476 as we are calculating in crores.

How to calculate tax rate ?

One quick way to do this is by dividing Tax by PBT..you will know approximately the tax rate %.

Sir

then tax rate for the year 2014 is 32% (170/537) and for the year 2013 it is 32%(135/422) .

Average of these value is 32% then why have to taken 34% in calculating tax sheild ?

Thank you for pointing out the error. We have made the necessary corrections.

please clarify how can you calculate 170 for Year 2014 and 135 for Year 2013?

Less: Tax expense FY14 FY13

Current tax 1,580.00 1,377.97

Deferred tax (credit) / expense 106.23 (24.51)

Earlier year’s (excess) / short provision 6.11 (2.34)

ok.Got it

Add all these value then get tax value for FY.

sir while calculating CAGR you have taken n=4 years… but shouldn’t it be 3 years. as the initial year itself is not included??

You can include the 4th year…for example if the investment was made on 1st Jan then the money has the whole year to compound.

From which sheet you taken Profit before Interest & Taxes = Rs.496 Cr

In ROCE and how?

why you taking finance cost(EBITDA and ROA) 1 cr else 7 cr is given in AR P&L statement?

Please guide me.

Thank you for pointing out the error. We have made the necessary corrections.

How to calculate the tax rate(%) in ROA???

Tax rate is a % of PBT that goes towards the Income tax obligation of the company. You can calculate the same by dividing Income tax paid by PBT.

Thanks for your awesome work!

Shouldn’t the net profit margin under DuPont model be 10.5% as against 9.2% mentioned? This would also make ROE’s calculated from both the method approximately same, which makes sense mathematically. Please clarify.

Need to double check this…will get back on this.

Net profit Margin is 10.5 instead of 9.2 I guess its a typo which in turn gets cascading effect

Yes, it is 10.5. We had made the necessary corrections.

That was fast…. This is awesome material, appreciate the effort. Would look forward to a book from varsity soon. Keep up the good work

Do we need to add excise duty tax in the income tax paid for finding the tax rate

Nope, you can exclude that. Tax rate is usually Income tax.

How did u calculate PBIT?? in ROCE??

–Shouldn’t it be Profit before tax-finance cost=536.7-0.718= 535.98 Cr, But, you got 537.7 Cr.

Micheal – Thank you for pointing out this. The Profit before interest and Taxes are calculated as follows :-

As per ARBL balance sheet – PBT 536.67 and Finance Charges are 0.718. In order to calculate PBIT the Finance costs should be added back, as it was already deducted, hence the PBIT is 537.7.

Can i use the formula for tax rate(%)=PAT/Profit Before Tax,Is tax rate and tax burden the same??.

Michael – Yes you can use the formula. Both are same, although I prefer calling it the tax rate 🙂

Is return on capital employed and return on capital invested the same?But Return on capital employed=Equity+Long term+short term debt & Return on capital invested=Equity+Long term+short term debt+capital lease obligation{i read this from a blog named Old value school.com} & what does capital lease obligation mean and how do we find it in the financial statement.

Micheal – Both are same.

Honestly I’m not sure about ‘Capital lease obligation’. Have not come across this in the Annual Report of Indian companies. Need to figure this out.

Thank u for answering my earlier Queries.Can a student with out a finance background be a fundamental analyst and enter in to stock investing,u can see lots of people with the required skills on the loosing side of the stock market.

Oh yes, you certainly can. You don’t really need to have a background in Finance to be a fundamental analyst. However if you intend to make this your profession then you may need to have a PG degree of sorts.

Hi Kartik,

How did you arrived at Shareholder’s Equity figure.

I think you mention Shareholder’s Equilt = Asset – Liability. And for Balance Sheets, Asset should always equal to Liability.

Then shouldn’t be Shareholder’s equity always zero ?

Net worth = Assets – Liability

Shareholders equity = Share Capital + Reserves

Awesome work, I have few doubts,

1) In ROE DuPONT calculation,

Is Net Sales 3437 Cr/3482 Cr ( from P&L ). Are we excluding OTHER INCOME (46Cr) from Net Revenue ?

In either Values (3437 / 3482), the calculation goes like this… 367/3437 = 10.6 % (or) 367/3482 = 10.5 %.

But it is 9.2% there.

2) Because of this While calculating ROE by normal way and DuPont way, there is a huge difference 25.9% and 30.31%

I have got both way of calculation ~ same… ( 10.5*1.75*1.61)= 29.58 and other one is 30.31%.

3) what is the avg ROA of Top indian companies, is it > 15% ?

1) Excluding other income is a good idea. I’ll double check the numbers.

2) Another way to put this is, companies which display >15% ROE/ROA are usually top 🙂

Thanks … if possible please update the numbers.

Sure Abhilash, will look into this as soon as I can. Thanks for your patience.

Hi, sir

ROE=Net profit Margin*Asset Turnover*Financial Leverage

ROE=Net Profits/Avg.Shareholders Equity

can we use both formula to calculate ROE?

but different values come in both formula……is it ok?

You can, but the Dupont method is more elaborate. Suggest you use that.

While calculating ARBL’s Return on Asset(ROA), It is written Interest -7 and tax rate-32%

how it came this value?….

Hi,

I got the answer…….Interest is nothing but finance cost so ARBL’s finance cost was 7 right

and average tax rate is 32%

Yup.

in EBITDA calculation-

why finance cost and depreciation subtracted from total expense for calculating operating expense?? finance cost is also a part of operating expense

Because the EBITDA is supposed to reflect pure operational efficiency of a company.

plz point out what will be shareholders equity in calculating ROE?

where to find this value and what is it in ARBL ?

We have put up the calculation already. Suggest you check screener.in for latest values.

how can higher financial leverage means higher debt??

Financial leverage helps us answer this question – ‘For every unit of shareholders equity, how many units of assets does the company have’.

higher value should be good for company and investor?

Leverage refers to debt. Suggest you read the section on Return on Equity here – http://zerodha.com/varsity/chapter/financial-ratio-analysis/

I calculated financial leverage(asset/shareholders fund) of exide. It came out to me .6

It means for every rs 1 of shareholders money company has asset of rs .6. ?

so less than 1 ratio is considered good or bad?

Assets/Shareholders alone does not really convey much about leverage. I’d suggest you look at debt to equity as well. Value of 0.6 conveys a healthy ratio.

Is there any automated tool to carry out the fundamental analysis like you did in this chapter in Zerodha ?

No, but tools like screener.in will help.

RoE = Net Profits / Avg shareholders Equity

From the annual report we know for the FY14 the PAT is Rs.367 Crs

RoE = 367 / 1211

= 30.31%

From where 1211 value is taken?

In annual different value is given

shareholders fund

share capital-170

reserves and surplus-13456

Hi Rohan,

You can find the details in the Financial section of the Annual report, under the Balance Sheet.

The Shareholders funds for FY13 = Rs.1059 Crs

The Shareholders funds for FY14 = Rs.1362 Crs

Therefore Average shareholder equity = Rs.1211 Crs

Financial Leverage = Average Total Assets / Average Shareholders Equity

average shareholders equity=share capital+ reserves and surplus

shareholders equity means money from shares. Then why reserves and surplus included in this?

Avg Shareholder Eq = Avg of this year’s and previous year’s Shareholder’s EQ.

Shareholders equity is the net worth of the company and not money from shares. The net worth includes both share capital and Reserves and Surplus.

Hi Karthik, While calculating the interests for calculating RoA for one of the stocks i found that the financial costs include the below point

-Interest to banks

-Interest others

-Amortisation of ancillary borrowing costs

-Cash discount

-Bank charges

Now will the interest for the RoA include all the above points given under the financial costs or will it only consider the Interest to banks and Interest others?

It should consider all these charges.

Hi Karthik

The EBITDA you calculated in the above table for 4 years 2011, 2012, 2013, 2014 i.e. 257, 340, 451, 560 respectively does not match with the EBITDA numbers given in AR of FY14 for the same years i.e. 258.8, 357,465.8 and 575.8

Why is that so? Please Explain.

I’ve taken the restated numbers to represent the most accurate value. I guess this is where the difference is coming from.

Hi Sir, thanks for such a tutorial. I am a slow learner. It may take some time for me to digest them. meanwhile I thought of asking you this. Is there a place where I can get all these ratios for each stock rather than I calculate it. I am thinking like driving a car. I know to drive a car but do not know how it works. can that theory be applied here.

Sure. Check out ratestar.in or screener.in , both are really good source of data.

Hi karthik ,I think the logic of taking average of 2 years equity and 2 years debt be applicable in calculating ROCE vis a vis Average assets while calculating ROE ,because the average of both produce the current returns,kindly correct if I’m wrong

Not sure what you mean by – “because the average of both produce the current returns”, can you please elaborate so that I can understand this better? Thanks.

sir,

For analysis of company which numbers should be taken i.e standalone or consolidated statements. And the dividends are paid on which numbers?

Consolidated statements for both your queries.

Hi Karthik,

Hope you are doing well.

I have doubt in the calculation formula of EBIDTA. I have cross checked multiple websites and all of them have there own formulas of calculation EBIDTA. However the most commonly used formula was:

Total Revenue – Operating Expenses = EBITDA.

In the above mentioned formula giaven by you it is: Operating Revenue – Operating Expenses = EBITDA.

Which one is correct? Also, please check the the given link. I have made two calculations based on these two formulas and result were very different.

-Last

By checking the CAGR of both the formulas what will be the effect of them? AS one CAGR is positive and one is negative.

https://s22.postimg.org/bxoozup35/EBIDTA.png

I’d suggest you consider the Total Revenue – Total operating expense = EBITDA. This would be a bit conservative, better that way.

Dear Karthik

Why is there a difference while calculating the ROE by both method

1st: 25.9%

2nd: 30.31%

Ideally it should not – I’m guessing its because I’m using the restated numbers. Need to look into this again, will get back as soon as I can. Thanks.

Hi Karthik,

Asian Paints ROE for 2015-2016 is coming 1800% , net profit 1726.21 cr. Equity 95.92 cr. can a ROE be this high.

Regards,

MSP

Unlikely, you must recheck the number. Its 10 year average is more in the region of 35%. Check this – https://www.screener.in/company/ASIANPAINT/consolidated/

Hi Karthik,

AP is mentioning share capital 95.92 cr and consolidated profit 1726 cr

https://www.asianpaints.com/content/dam/asianpaints/website/secondary-navigation/investors/financial-results-2/2015/Asian%20Paints%20Limited%20-%20Annual%20Report%202015-16.pdf.

Am i looking , right numbers?

Regards.

MSP

You will also have add Reserves to this. Remember Reserves & Surplus is basically undistributed profits, belonging to shareholders. So divide the PAT by share capital + Reserves & Surplus and check the numbers again, please. Thanks.

Hi Karthik,

Thanks, now its coming correct.

Regards,

MSP

Glad 🙂

Hi Karthik,

Tata Chemical 2015-2016, Shares outstanding 25.82 cr. Reserve and Surplus 6033.58 cr , PAT 780.16 cr , EPS is coming 0.12, they are reporting 30.62. they are not including reserve and surplus, why so?

Regards,

MSP

I guess you’ve not converted the shares outstanding to Crores.

Hi Karthik,

I had converted to cr, in ROE we include general reserve, for EPS also we need to include general reserve?

Regards,

MSP

EPS is PAT divided by number of shares, reserves do not come into picture here.

Hi Karthik,

Thanks, now i am clear on this.

Regards,

MSP

Great!

Hi Karthik,

Tata motors ROE is coming 16%, Financial leverage 3.70, what does this mean? especially Financial leverage of 3.70.

Regards,

MSP

It indicates the presence of debt. You may want to double check on that.

Hi Karthik,

Avg. Asset 253977.795 cr, Average share holders equity 68522.295 cr, figures taken from http://www.tatamotors.com/investor/annual-reports/, for 2015-2016. 2014-2015.

Regards,

MSP

hello Karthik, when we have asset turnover in Dupoint analysis, do we need ROA ratio?, if yes then whats the difference between them?

Asset turnover and Return on asset (ROA) are two different ratios 🙂

Check this – http://www.financeformulas.net/Return_on_Assets.html

While calculating RoA how did you come up with the interest amount or finance cost 7 crs and avg. tax rate as 32%?

And while calculating Asset turnover ratio I think you taken net sales wrong figure . It is RS. 34036.12 million YOU TOOK AS 3437 CRS

I’ve converted the numbers to Crores throughout as its more intuitive for most of us to understand.

In EBITDA, what is the meaning of “Interest Tax Depreciation”?

It just means that – Interest, Tax, and depreciation.

Hi Team,

The figure of finance cost taken in the calculation of ROA is wrong…The amount of finance cost given in the annual report is 7.18 in million rupees which equals to .72 CR/ 72 lakhs..

Let me look through this, Gaurav. Thanks.

Under return of asset you have taken finance cost as 7 crs whereas by the balance sheet it is 70 lakhs. Please have a look and correct

Another small issue, once you download the PDF, a few chapters are repeated(The ones on financial ratios)

And, really thank you for this work.

Thanks for pointing that out, Raja. Will check on both the issues.

Can you please explain DuPont Model 3 points and 5 points?

Dont think we have discussed the Dupont in detail. I’ll probably do that one of these days as a supplementary note.

Small spelling correction:

EBIDTA Margin = EBITDA / [Total Revenue – Other Income]

Its actually EBITDA Margin

Thanks for pointing this 🙂

Sir, i have few doubts;

1.Does Asset Turnover and ROA convey the same thing but in different way?

2. What does this mean ”if the financial leverage is 4, this means for every Rs.1 of equity, the company supports Rs.4 worth of assets”?

No, Asset T/O indicates how efficiently you are using the assets you’ve invested in. ROA on the other hand, indicates the return on the asset you have.

It means for every 1 Rupee of your own, you have borrowed Rs.4.

Why dont we depriciate Tax form operating expenses in EBITDA?

Tax cannot be depreciated, Ayush. If you are talking about deducting, then yes, you can do that and consider just EBIT.

Hi Karthik,

For PAT, we use Total Revenues (which includes the ‘Other Income’) in the denominator. Then why do we say that Net Profit Margin in Du Pont is same as PAT when we use Net Sales (which excludes Other income ) in the denominator ?

For estimating pure operational efficiency, you will have to exclude other income.

Hi Karthik,

Thank you for the module. Regarding ROE and ROCE ratios, Profit was considered for obtaining ratios. However for ROA, “Net Income” had been considered for calculation. Does this have any significance or it is just the way the ratios have been defined.

Profit is net income.

sir, in EBITDA why do we consider other expenses as operating expenses whereas we are not considering other revenue as operating revenue?

Hmm, ideally speaking EBITDA should reflect operating efficiency. So you can exclude other income. However, if you look the nature of other expense, you will notice a lot of expenses, which are core to the operations. Hence you cannot exclude this.

Karthik,

Nice explanation. I can download any organisation in the excel format from screener, as you suggested, but i did not see financial Ratio analysis in Data Sheet. Can you please include that in that excel or if you have any sample, can you please send me one

Thanks in advance.

Will try and come out with a module on Financial modeling which will include this.

Adding to above, I see ratios in ratestar website, but does not have enough ratio analysis, dont have link to download as excel and value looks different comparing to screeners.

Not really.

Hi Karthik.

1. What is the difference betwee ROA and ROCE apart from the tax shield number?

2. For financial leverage you have mentioned Avg total assets/Shareholders equity. What about Debt/ equity ratio.?

3.Doesnt ROA gives a better idea than ROE as it takes into consideration the debt as well. ?

Thanks

1) ROA measures the utilization of assets of the company, measured in terms of returns. ROCE, on the other hand, does the case for capital employed

2) Yes, D/E also gives you a sense of financial leverage

3) These are two individual ratios measuring two different aspects of the company

I am trying to search EBDITA margin in screener.in but I am not able to find that. Can you please help me with this.

EVEBITDA is available , is it the same thing?

Why don’t you check out – https://screener.smallcase.com/welcome

sir in case of pnb housing finance PAT has increased by 41% CAGR in the last 5 years while ROCE is only around 1.5% in last 5 years. why is there so much difference?

ROCE on banks can be a little tricky, Preetam….especially since a bank’s balance sheet is highly leveraged.

ROCE should be EBIT (1-T)/ Total capital, instead of EBIT/TC as we have to pay taxes.Please correct me in case you think other wise.

If you are considering a tax shield?

If we want to calculate EPS for 5 years, so how do you get data apart from last two years? Is Annual Report the only source?

Its not the only source, but its the best source.

hi, i am new to share market, I am doing positional trading. but have problem about dividend. i have REC share and dividend is already declared on 0n 15/07/2017 but i have confusion about, how long i have to hold this stock. is it till book closer date,or till complete book closer period. i have no clue please guide.

The dividends will be received by all those shareholders whose names show on the list of shareholders, on the record day. So you will have to wait till the record date.

thanks for your valued reply

Welcome!

In some annual reports they give Profit for the year value and then add/subtract profit/loss attributable to non-controlling interest and then they arrive at Profit attributable to owners of the parent.

Eg:

Profit for the Year = 2,713.51crs

Profit/(Loss) attributable to Non Controlling Interest = (1.41) crs

Thus, Profit attributable to Owners of the Parent = 2,714.92 crs

so, which PAT to take for calculation purposes?

Thanks

You need to consider – Profit attributable to Owners of the Parent

In Calculation of Net Pproft margin you have taken Total revenue amt 3482 crs as Net sales, but in calculation of Net sales/Avg Total assets (ROE), you have taken Operating revenue amt i.e. 3437 crs as Net sales.

So, which to take for Net sales, operating revenue or total revenue?

Ah, this could be a typo. You need to take the operative income (without including other income) into consideration.

So, In Net profit margin calculation it is mentioned that “this is same as PAT margin” in PAT margin it is Total Revenue , but here it is Net Sales, how both are same? please clarify

Thank you

Net sales are essentially revenue from the operations of the company, however, total revenue includes other incomes as well. Hence its prudent to consider revenue just from the operations for PAT margins.

hi sir, pls tel me how to forecast ebita for next year , say we are in 2017 so hw to forecaste or calculate ebita for 2018, 2019 and 2020. pls reply me here or mail me at [email protected]

This will require a little bit of financial modelling, Binay. Plan to take this up as an entire module sometime soon.

Hello,

How do you got 4 year EBITDA CAGR growth of 21%?

Ramana

How as in the technique to calculate the CAGR?

based on what you have taught above , i tried calculating EBIDTA for tata motors reffering to the latest Annual report in April 2017. I was unable to get the EBIDTA figure that they have mentioned

Also can you please throw some light on “Other comprehensive income/(loss):” as this is included in Profit and loss and shows loss of (27,494.57)

The Other comprehensive income – seems like the other income. Have you looked at the associated note? Also, are you looking at consolidated statements?

Yes sir and i dont seem to be arriving at any answer. Under other comprehensive income they seem to have mentioned a loss. Not sure if it needs to be considered and how important it is .

Also ROE as per money control is -11.91 .

I reffered the annual report from Tata motors website but unable to get -11.91 as ROE

Hmmm, not sure Vedant. Let me check the AR sometime soon.

sorry their consolidated return on equity is -12.83. dont understand how they are getting this figure

is there anything available on Financial modelling

Not yet, hopefully soon.

Hello sir

In the ROE first you wrote different formula to calculate and after Du Pont method you again wrote a different formula

1. RoE can be calculated as: [Net Profit / Shareholders Equity* 100]

2. However if you wish do a quick RoE calculation you can do so the following way:

RoE = Net Profits / Avg shareholders Equity

Please clear which is actual formula to calculate ROE except DU PONT Model

Thanks

I’d suggest you stick to – RoE can be calculated as: [Net Profit / Shareholders Equity* 100]

Thanks for your reply

Welcome!

No words to say… extraordinary work…

Please provide link to financial ratio pdf… bcoz module 3 is available upto 85 pages only..

Will check this, thanks!

Sorry… now again when i downloaded, it had full 172 pages…. i don’t know how this occurred… anyways thanks for your reply… i read many books… but now i became a great fan of your english writing skill… simply superb power of expression…

Happy learning, Rajesh 🙂

Hi Karthik,

I am a bit confused while calculating CAGR – PAT for NTPC. I have taken 5 yrs PAT data i.e.

2012 — 12590.78

2013 — 11403.61

2014 — 9986.34

2015 — 10182.81

2016 — 10713.94

I have used — (10713.94/12590.78)^(1/5) – 1. (ending value/beginning value)^(1/no. of years) – 1

Can you plz guide me in calculating CAGR here ?

YEs, that is the correct formula.

Sir,

Can financial leverage be calculated as follows

EBIT/EBT

If yes how is it different from the given formula

I’m not sure if this works 🙂

Hi Karthik,

I am looking at a company whose financial leverage ratio is 11 but it has zero long term debts. It has had zero long term debt for the last many years.

How do I interpret this?

sorry my mistake it is actually 1.1 and not 11 🙂

You got me wondering 🙂

How are you calculating financial leverage?

in Vishal pizza example ,for second case liability should be equal to 2000 and not 10,000 otherwise equation( shareholder equity=total asset -total liability ) will not hold!!!Please clarify.

Liability to a company includes shareholders’ fund, non-current liabilities, and current liabilities.

In this case, Equity Capital of Rs 8000 contributed by Vishal and Rs 2000 as external debt.

You can read more on this in Chapter 6 & 7 of this module that covers Balance Sheet

The balance sheet equation is Total Assets = Total Liabilities, which holds in the case of this example.

Hi,

in this documents ,it is stated that we need to compare the financial ratio with its peers

I think this may be true if two company size or same .

But in real scenario ,any companies size are not same as another .

in this case , how it will be effective if comparing the financial ratios with its peer?

can you please elaborate this ?

I agree, the comparison will be effective only if the companies you are comparing are of similar market cap size.

Hi karthik,

Currently i am reading Annual Report of Amar raja for year 2017. One page no. 9 there is a ratio called RONW%. can you please brief me on the same.

That is Return on Net worth, which is similar to ROE.

Hi Sir,

1.Why is not correct to compare the financial ratio of two different market cap companies?

2.As per balance sheet equation Assest = Liability,then does that mean ROCE (accounts for liability side) and ROA should be same?If so they why two different calculation?If not in what aspect they vary?

3.If the leverage ratio = Avg Asset /Avg Equity is less than 1, then where does the company kept its remaining equity cash?Because in this case no debt would be there,and if so then how come the balance sheet equation Assest = liability get balanced?

4.In ROCE why is PBIT considered ? Why can’t PAT+Interest be considered ? or simply PAT?

1) You can compare to get a sense of how the companies are doing. No harm in doing this. But be aware that the size of both the companies are different

2) No, this is not true. The denominator for both these ratios are different

3) Please dont mix up the ratios with the balance sheet equation

4) Becuase we are interested in operating profits.

In ROA, how did the average tax rate (32% here) calculated?

Guess that was the average corporate tax rate applicable at that point in time.

While calculating ROE you are considering Net Profit Margin 9.2% but we have calculated it as 10.5% while calculating PAT margin . I’m confused here.

Ah, I need to check this, Gourav. Anyway, here is how I prefer to calculate the

Net profit margin = PAT / Operating Income.

Make sure you remove the other income component.

Sir, When you calculated ROA your numerator was PAT + i(1-t) and I understood your explanation for using i(1-t).

But the similar logic applicable for ROCE. isn’t it? Why did you use EBIT in this case? TAX shield should be considered here as well…?

I guess this has been explained in the same chapter?

Sir, Why do we have two ratios ROA and ROCE, they are almost measuring the same thing or I am unable to understand the difference between the two because A in ROA is nearly equal to CE in ROCE

Asset is in the form of fixed assets, but CE in ROCE represents the capital employed.

How to calculate EBITDA and EBITDA Margin of Karur Vysya Bank or Bank Stock?

Total Expense – Total Revenue = EBITDA

Total Expense / Total Revenue = EBITDA Margin

As Tax shield is interest*tax rate , company wont have to pay this amount , so this can be considered as a profit .

So, Should the ROA formula be [Net income + interest*tax rate] / Total Average Assets instead of [Net income + interest*(1-tax rate)] / Total Average Assets

Can you clarify on this ?

The formula is Interest *(1-tax rate).

To rephrase my question, why is it Interest *(1-tax rate) , when profit in Tax shield is Interest *tax rate or am I missing something in this calculation

Hmm, I’m really not sure about the question. Let me relook at this, please. Thanks.

Shouldn’t the net profit margin be 10.5% rather than 9.2% as mentioned in Dupont Model or am i missing something??

You can simply divide the PAT by Operating revenues (not including other income) for a better estimate.