Evaluating stocks - Financial Ratios

Long Term Debt to Equity

Long term (LT) Debt to Equity ratio is calculated as the ratio of LT debt of the company to the shareholders equity of the company for the most recent financial year. Long term debt refers to the loan amount raised by the company, which is repayable at least only after 1 year. Shareholders equity is the sum of profits retained by the company and amount invested into the company by shareholders

This ratio helps understand the extent to which the company is raising loans to fund projects. Suppose the LT debt of the company is Rs.130 and shareholders equity is Rs.100. Then LT debt equity ratio is 130/100 = 1.3

Interest expense is a fixed cost that has to be paid on loan / debt raised by the company. Higher the debt raised more the interest cost. So if the company funds projects using more of debt funds, interest expense automatically increases eating into profitability of the company. Hence, all other things remaining the same, company with lower long term debt to equity ratio is preferable compared to ones with higher ratio
A company with decreasing trend in LT debt to equity ratio over the medium term will usually see improved profits and record higher ROE. LT debt to equity ratio of companies operating in the same sector can also be compared with each other

Debt to Equity

Debt to Equity ratio is calculated as the total outstanding debt of the company divided by the shareholders equity of the company for the most recent financial year. To understand it better, please read about long term debt to equity ratio above. Total debt is the sum of all kinds of loan amount raised by the company regardless of repayment schedule

This ratio helps understand the extent to which debt capital is used to fund projects as well as to meet day to day working expenses of the company. Higher the debt capital, higher the interest cost leading to lower profits. Hence companies with lower debt to equity ratio are more preferable. Debt to equity ratio of companies operating in the same sector can be compared with each other

Quick Ratio

Quick ratio is calculated as total current assets minus inventory for the most recent financial period divided by total current liabilities for the same period. Current assets include short term assets like cash, inventory and receivables whereas current liabilities includes obligations that are due within 1 year such as short term debt, accounts payable etc. Since inventory cannot always be sold off at short notice, it is not considered a liquid asset

Suppose total current assets of a company is Rs.250, inventory is Rs.50 and current liabilities is Rs.300, quick ratio can be calculated as (250 – 50) / 300 = 0.67. So the company has Rs.0.67 quick asset to meet every Rs.1 current liability
Quick ratio allows to understand how quickly a company can meet its short term financial obligations, by monetising liquid assets. Higher the quick ratio better the liquidity situation of the company. Quick ratio of 2 or more companies operating in the same sector can be compared with each other

Current Ratio

Current Ratio is calculated as total current assets divided by total current liabilities for the most recent financial period. Current assets include short term assets like cash, inventory and receivables whereas current liabilities includes obligations that are due within 1 year such as short term debt, accounts payable etc

Suppose total current assets of a company is Rs.250 and current liabilities is Rs.300, current ratio can be calculated as 250 / 300 = 0.83. So the company has Rs.0.83 current assets to meet every Rs.1 current liability
The ratio helps understand the company’s ability to pay off its short term liabilities using its current assets. It is important to understand that while current ratio of 1 is considered optimal, an extreme divergence on either sides from this point is not desirable. A very low ratio indicates that the company is having trouble collecting from its debtors or takes a long time to sell inventory whereas a very high ratio indicates that the company might be holding lot of cash without investing the same appropriately

Cash Conversion Cycle

Cash conversion cycle is calculated as the sum of average inventory days and average receivables collection days minus average payables payment period for the financial year.  The ratio, expressed in number of days, helps understand the length of time it takes to convert raw material into inventory, sell the inventory, collect cash from debtors and pay off creditors who supplied raw materials

For example if the company takes 28 days to manufacture the product and sell it on credit, 13 days to collect from debt holders and has 32 days time to pay of its creditors – cash conversion cycle is 28+13-32 i.e 9 days
Cash conversion cycle indicates how efficiently the company is using short-term assets and liabilities to generate cash.  The lower the number of days, the more efficient the company is in converting raw material into finished products, selling the same and collecting cash

Interest Coverage Ratio

This ratio is calculated as earnings before interest and taxes (EBIT) for the most recent financial year divided by the interest expense for the same period. Earnings before interest and taxes is calculated as sales minus operating expense – which includes cost of goods sold, selling and general expenses etc. Interest expense is paid out on the outstanding debt amount of the company, higher the debt higher the interest pay out

Suppose EBIT of the company is Rs.120 and interest expense is Rs.50, interest coverage ratio is 2.4, indicating that the company has Rs.2.4 for every Re.1 of interest payment
This ratio helps understand whether the company can pay off its interest obligations in a timely manner. If the ratio is less than 1, it indicates that the company’s operating profit is not sufficient to make interest payments and that the financial health of the company is in dire straits. A number equal to 1 means all operating profits will be expended towards make interest payments and net profit will be zero. Higher the coverage ratio above 1 better the financial health of the company