A.

Profitability ratios

As the name suggests, profitability ratios determine the profitability of a

company. The ratios reveal the performance of a company in terms of
generating profits. They also convey the competitiveness of the management.
There are various profitability ratios. For the purpose of fundamental
analysis, here are four profitability ratios.

1. PAT margin

Profit After Tax (PAT) margin is calculated by deducting all company

expenses from its total revenue. It identifies the overall profitability of a
company. The formula to calculate the PAT margin is,

PAT margin = [PAT / Total revenue]*100

The higher the PAT margin, the better the profitability of a company. It is
referred to as Net Profit Margin (NPM). It should be compared with the
previous years’ trends or competitors to understand more deeply.

2. Return on Equity (ROE)

It is a critical ratio that assesses the return earned by the shareholders on

every unit of capital invested. ROE is useful in measuring the company’s
ability to generate profits from the shareholders’ investments. It represents
the efficiency of a company in generating profits for its shareholders. It is
calculated as,
ROE = [ Net income / Shareholders’ equity ] * 100
To calculate the shareholders’ equity, subtract a company’s total liabilities
from its total assets. You can get this information from the balance sheet.

Shareholders’ equity = Total assets – Total liabilities

High ROE signifies good cash generation by the company, conveying a good
performance by management, whereas low ROE indicates otherwise. ROE of
a company can also be compared with its competitors and past years’ trends
to get a better understanding.

3. Return on Assets (ROA)

It is a profitability ratio that measures the profitability of a company in

relation to its total assets. It shows if the company is using its assets
efficiently to generate profits. To calculate the ROA, divide a company’s net
income by its total assets.

ROA = Net income / Total assets

The higher the ROA, the more efficient management is in utilising the
economic resources. Both ROE and ROA reflect how well a company utilises
its resources. However, there is one key difference which is the way they
treat a company’s debt. ROA captures how much debt a company carries as
its total assets include all kinds of capital. On the other hand, ROE leaves out
all the liabilities and only measures the return on a company’s equity.

If a company has more debt, its RoE would be higher than its ROA.

4. Return on Capital Employed (ROCE)

It is useful in understanding how well a company is utilising its capital to

generate profits. It takes into consideration all kinds of capital, including
debt. To calculate ROCE, divide Profit Before Interest and Tax (PBIT) by the
total capital employed.

ROCE = PBIT / Total capital employed

Where the total capital employed = Equity + short-term debt + long-term
debt

PBIT is also known as Earnings Before Interest and Tax (EBIT). You can
find this information in the income statement of a company.

A higher ROCE suggests efficient management in terms of capital employed.

However, a lower ROCE may indicate a lot of cash on hand as cash is
included in total assets. As a result, high levels of cash can sometimes skew
this metric.

B. Leverage ratios

Often referred to as solvency ratios, leverage ratios measure a company’s

ability to sustain its day-to-day operations in the long term. It measures a
company’s financial health by determining its ability to meet its long-term
debt obligation. Let’s look at two leverage ratios that will help us determine
the potential company to invest in:
1. Debt-to-equity ratio

It is one of the prominent ratios in fundamental analysis and is often referred

to as the risk ratio. The debt-to-equity ratio calculates the weight of a
company’s total debt against total shareholders’ liabilities. It is calculated as

Debt-to-equity ratio = Total debt / Shareholders’ equity

Where the total debt = short-term debt + long-term debt + fixed payment
obligations

A value of one on this ratio signifies that there is an equal amount of debt and
equity capital. A higher ratio (more than 1) indicates higher leverage,
whereas a lower than 1 signifies a relatively bigger equity base with respect
to debt. The maximum acceptable debt-to-equity ratio for many companies is
between 1.5-2 or less. For larger companies, debt to equity ratio of 2 or
higher is acceptable. Ultimately, an ideal debt-to-equity ratio varies across
companies based on the sector they belong to.

2. Interest coverage ratio

Often referred to as the debt service ratio or the debt service coverage ratio, it
gives insights into how easily a company can repay the interest on its
outstanding debt. The interest coverage ratio determines the time (typically
number of quarters or years) for which interest payment can be made with the
company’s current available earnings. It is calculated as

Interest coverage ratio = EBIT / Interest expense

The lower the ratio, the more the company has a debt burden. The company’s
ability to pay back the debt is questionable when the interest coverage ratio is
only 1.5 or lower. The analysts usually prefer an interest coverage ratio of 2
or more.

C. Operating ratios

Often referred to as activity ratios, they measure the efficiency at which a

business can convert its assets into revenues. Operating ratios help us
understand the efficiency of a company’s management. Profitability ratios
convey the company’s efficiency, which is generally determined by
measuring the operating ratios. Hence, it is difficult to classify these ratios.

1. Working capital turnover

To run a company’s day-to-day operations, working capital is required. The
working capital turnover ratio measures how much revenue a company
generates for every unit of working capital. It is commonly referred to as net
sales to working capital. The formula to calculate it,

Working capital turnover ratio = Revenue / Average working capital

The higher the working capital turnover ratio of a company, the better sales it
can generate in comparison with the funds they have used to execute the
sales.

2. Total assets turnover

This ratio indicates a company’s ability to generate revenues with the given
amount of assets. It is a ratio of the total sales or revenue of a company to its
average assets. The total assets turnover ratio is calculated annually. It is
calculated as

Asset turnover ratio = Operating revenue / Average total assets

A higher total assets turnover ratio conveys that a company is using its assets
efficiently to generate more sales, whereas a lower ratio indicates a
company’s inability to use its resources effectively.

This ratio tends to be higher in certain sectors. For example, sectors like retail
usually have small asset bases but higher sales. Hence, they have the highest
asset turnover ratio. Conversely, sectors like real estate and utilities have
large asset bases, thus, low asset turnover.

D. Valuation ratios

Valuation ratios measure a company’s worth. It analyses whether a

company’s current share price is perceived as its true value. It compares the
cost of security with the perks of owning the stock. Let’s explore some
valuation ratios.

1. Price to Earnings ratio (P/E ratio)

It is a popular ratio that analyses a company’s share price to its earnings per
share. Due to its popularity, it is often called a ‘financial ratio superstar’. It
helps in determining if a stock is undervalued or overvalued.

P/E ratio = Market value per share / Earnings per share

To determine if a stock is undervalued or overvalued, the P/E ratio of that
stock is compared with other stocks of the same industry and/or with the
sector P/E. A high P/E ratio could mean that the stock price is relatively
higher than its earnings and possibly overvalued. In contrast, a low P/E ratio
might indicate the stock’s price is low relative to earnings and perhaps
undervalued.

2. Price to Sales ratio (P/S ratio)

It compares the stock price of a company to its revenue. It helps in

determining how much an investor is willing to pay per rupee of sales. The
formula for the P/S ratio is

P/S ratio = Current share price / Sales per share

Where the sales per share = Total revenues / Total number of shares

It is better to compare the P/S ratio of similar companies in the same industry
to get a deeper understanding of how cheap or expensive the stock is. The
higher the P/S ratio, the higher the valuation of the company. Conversely, a
low ratio indicates the stock is undervalued.

3. EV/EBITDA ratio

Enterprise Value (EV) measures a company’s total value. It is compared with

a company’s EBITDA to determine how often an investor has to pay
EBITDA if they were to acquire the entire business.
Similar to the P/E ratio, the lower the EV/EBITDA, the lesser the company
valuation. A high EV/EBITDA signifies that a company is highly likely to be
overvalued. This ratio is used in comparison with other companies in the
same sector. Hence, cross-sector comparison won’t be helpful. It is
commonly used to figure out what multiple a company is currently trading at.

Conclusion
Fundamental analysis is the first step you take when you are looking for
long-term investments in assets like stocks. It is an extensive process but
provides you with your potential long-term investment plan. Hence, take
your time in understanding the financial statements, stock growth of a
company, and evaluating the crucial financial ratios. Tickertape is your
complete destination for fundamental analysis. From getting financial
statements to ratios, adding stocks to the watch list, to investing in them
directly, everything can be done here. Start your investment journey now!