Ratio Analysis: ROE, ROCE, ROA, Debt/Equity Ratio, Interest Coverage Ratio, Current Ratio, P/E Ratio, and EV/EBITDA Ratio.

Ratio Analysis

The quantitative analysis of a company is all about checking whether the company is profitable, sustainable, and finding the right valuation for the company. In our previous article on financial statement analysis, we did check 

1. The profitability of the company from the P&L statement analysis.
2. The sustainability of the company from the Balance Sheet analysis.
3. The valuation of the company from the cash flow statement and DCF valuation model.

If we have checked everything then why should we analyze ratios? 

Just imagine you want to invest in the banking industry. There are several good banks out there, if you start by reading annual reports of each bank it will not take less than a month of full-time commitment to analyze all banking stocks thoroughly. If you are moderately passionate probably you will give up thinking its too time-consuming and end up starting SIP into a mutual fund. Ratio analysis is a good starting point to filter out 3-5 best stocks for analysis. The ratio analysis can be considered to be a binocular view of quantitative analysis. 

The screenshots shared above contains a list of banking companies listed in the Indian securities market along with their financial ratios. Imagine the efforts and time required for analyzing so many companies, but if you are one of those guys who understand ratios within 10-15 minutes you can easily short this list down to around 5 companies. This 10-15 minutes will reduce 85% of your work. 

A lot of people ask me if ratios are to be used first why don't you teach them first?

Because

1. If one doesn't know financial statements understanding ratios will be hard.
2. Lazy analysts start feeling as if there is no need for any further analysis.  

Now as we understand the importance of ratio analysis, let us discuss important ratios. 

Profitability Ratios

It is a no brainer to understand that one should invest in profitable companies, but how to know which company is more profitable. Profitability ratios are pretty helpful to check profitability in a glance. So let us discuss some important profitability ratios.

• ROE (Return On Equity): 

1. ROE is used to measure how much profit a company is making against the investor's money(Equity). One can say ROE is a measure of the efficiency with which the company uses investor's money. 
2. Higher the ROE better it is as it shows better efficiency.
3. I personally prefer to invest in companies with ROE of more than 15%.
4. ROE has a tendency to rise if a company is highly leveraged and it can be spotted if there is a huge divergence in ROE and ROCE.
5. Sustainability ratios need more attention in case of divergence in ROE and ROCE. 

• ROCE (Return On Capital Employed)

1. ROCE is used to measure the efficiency of a company utilizing its total capital including investor capital and borrowed capital.
2. Similar to ROE higher ROCE is preferable.
3. I personally prefer to invest in companies with ROE of more than 15%.
4. ROCE has a tendency to fall if the company is highly leveraged.
5. These opposite tendencies to react to debenture causes the divergence to occur in ROE and ROCE when a company is operating with high debenture.

• ROA (Return on Asset)

1. ROA is a measure of how efficiently a company is utilizing its total assets.
2. ROA is a good tool to analyze companies from capital intensive sectors such as mining.
3. The banking sector is also one important sector where ROA is given more importance than ROCE because of its nature of business.
4. While judging a company based on ROA it is important to compare it with peers as each sector has a different level of capital intensity. 
5. Higher ROA compared to peers is considered good.

Sustainability Ratios

Do you think you can make money by investing in a company that is heading to bankruptcy? Obviously no! That is why we have to check the sustainability of the underlying company. We have already discussed sustainability checking from the balance sheet with debt/equity and the current ratio. There is another important ratio to check the sustainability called interest coverage ratio. let us discuss all three ratios. 

• Debt/Equity Ratio

1. The debt/ Equity ratio is a direct indicator of leverage used by the company.
2. In my opinion, leverage is not a bad thing until it is manageable. Leverage helps companies grow at a faster rate but when it gets so big that it becomes unmanageable then it becomes a tool for self-destruction.
3. Generally, companies with debt/equity of less than 1 are considered good.
4. I prefer to invest in companies with debt/equity ratio of around 0.5.

• Interest Coverage Ratio

1. The interest coverage ratio is a measure of company's ability to pay interest on debenture.
2. It is the ratio of EBITDA/Interest Expenses.
3. Higher the ratio better it is.
4. Though an interest coverage ratio of more than 2 is considered good, I personally prefer to invest in companies with an interest coverage ratio of more than 5.

• Current Ratio

1. The current ratio is measure of a company's ability to pay its short term liabilities.
2. Generally, a current ratio of around 2 is considered good.
3. A too high or too low current ratio is not a good sign.
4. A lot of beginners get confused about why a high current ratio is bad. The reason lies in a deeper understanding of the balance sheet. One got to understand what current assets and current liabilities are, current assets are actually the payments to be received from clients and current liabilities are payment to be done to suppliers. A too high current ratio may be an indication of some big clients defaulting payments or at least not paying on time, which is a bad sign.

Valuation Ratios

This is the trickiest part of the investment process. Most retail investors choose good profitable and sustainable companies to invest. A lot can do that by commonsense investing as well but very few manage to buy them at the right valuation. The reason is they use valuation ratios to find the intrinsic value which is the wrong method. Valuation ratios and all ratios we discussed in this article should be used only for shortlisting companies for analysis and not for finding intrinsic value. The intrinsic value should be calculated with valuation models like the DCF model. For now, let us discuss valuation ratios.

• P/E (Price to Earnings Ratio)

1. The P/E ratio is the most familiar concept to an investor. It is a ratio of share's market price to companies earning per share.
2. A P/E ratio is a comparison ratio that can help you find cheaper stocks within the industry or peer group.
3. Lower P/E ratio compared to peers indicates cheaper valuation.
4. If P/E of any company is too low compared to peers then one should be cautious as lower P/E can be because of some issues with the company's qualitative factors.

• EV/EBITDA (Enterprise Value/EBITDA)

1. The EV/EBITDA ratio is very similar to the PE ratio but I consider it to be more reliable as it considers cash and borrowings as well.
2. The reading of the EV/EBITDA ratio is also very similar to the P/E ratio. 
3. Lower EV/EBITDA is considered a cheaper valuation in comparison to peers.

Note: 

• There are too many ratios and no one checks all of them. We have discussed only important ratios that are helpful in checking profitability, sustainability, and valuation of a company.
• We have not discussed formulas for calculating ratios as the ratios are generally available on information and data platforms such as moneycontrol, screener.in, ticker-tape, etc. I am not promoting any of these platforms you may choose the one you find suitable. 
• Retailers are generally trained to feel that the ratio analysis is analysis for investment decisions but let me tell you they are only good for screening or shortlisting companies and real analysis start after screening.

I hope you understood all the ratios we discussed in this article if you have any doubt please feel free to comment. I have already mentioned in the notes that we have not discussed the calculations part as it is not necessary but if still want me to discuss it, please comment below, we will discuss it in a separate article.

And don't forget to Read To Learn Investing.