As an investor in stock market, one has to read about companies, industries, balance sheets, P/L statements and cash flows
In this small thread 🧵, we will share with you 4 important ratios that every investor should understand and look at while analyzing any company (1/n)
In this small thread 🧵, we will share with you 4 important ratios that every investor should understand and look at while analyzing any company (1/n)
Before that, for the next 10 mins assume yourself to be a businessman with a business wherein you have invested Rs 1 cr of your own capital (equity or shareholder’s capital) and also taken a loan of Rs 50 lakh from the bank (debt)
(2/n)
(2/n)
Also, the business generates around EBIT (earnings before interest and tax) of Rs 35 lakh and PAT of Rs 22.50 lakh
When understanding ratios for the first time, it’s always easier to use simpler numbers and think in terms of your own business (3/n)
When understanding ratios for the first time, it’s always easier to use simpler numbers and think in terms of your own business (3/n)
ROCE – ROCE stands for Return on Capital Employed.
It basically measures the profits generated on the overall capital (debt + equity) employed in the business.
(4/n)
It basically measures the profits generated on the overall capital (debt + equity) employed in the business.
(4/n)
For ROCE, we look at profits before interest and the tax expenses to determine if the cos. returns are greater than cost of debt and equity
Normally, cost of debt is around 8-12% and therefore you would want your business to generate returns higher than the same
(5/n)
Normally, cost of debt is around 8-12% and therefore you would want your business to generate returns higher than the same
(5/n)
The formula we use for ROCE is [EBIT/(Debt + Equity)]
For your biz, as assumed above, the ROCE = [0.35 crore/ (Rs 1 crore + Rs 0.5 crore)] = 23.33%
In general, we look for companies where ROCE is improving and the company is more than able to recover the cost of capital
(6/n)
For your biz, as assumed above, the ROCE = [0.35 crore/ (Rs 1 crore + Rs 0.5 crore)] = 23.33%
In general, we look for companies where ROCE is improving and the company is more than able to recover the cost of capital
(6/n)
ROE – ROE stands for Return on Equity. Like ROCE, this too is a return ratio and is used to calculate the returns on the equity (shareholder’s capital) employed in the company
For calculating ROE, we look at the net profit attributable to the shareholders of the company
(7/n)
For calculating ROE, we look at the net profit attributable to the shareholders of the company
(7/n)
The formula for ROE is [PAT/ Shareholder’s equity]
In the above case, the ROE works out as = [0.225 crore/ Rs 1 crore] = 22.50%
ROE doesn’t give out a full picture because it doesn’t take into account the debt part on the capital employed side (8/n)
In the above case, the ROE works out as = [0.225 crore/ Rs 1 crore] = 22.50%
ROE doesn’t give out a full picture because it doesn’t take into account the debt part on the capital employed side (8/n)
Therefore, it’s important to look at both ROCE and ROE as a lot of times ROE might be very high and it could be because of high debt taken to run the business.
During downturn, high debt can prove to be lethal and ROE might crash because of high annual interest cost
(9/n)
During downturn, high debt can prove to be lethal and ROE might crash because of high annual interest cost
(9/n)
Debt to equity – This is a simple ratio and you may have come across it often.
using the above example wherein you deployed Rs 1 crore of your own and took a loan of Rs 50 lakh, the calculation for debt-to-equity ratio is as below:
D/E – [Rs 0.5 crore/Rs 1 crore] = 0.5
(10/n)
using the above example wherein you deployed Rs 1 crore of your own and took a loan of Rs 50 lakh, the calculation for debt-to-equity ratio is as below:
D/E – [Rs 0.5 crore/Rs 1 crore] = 0.5
(10/n)
Interest coverage ratio – While almost everyone has heard of and used debt to equity ratio, not many understand interest coverage ratio
This ratio determines how easy/difficult it would be for a company to service its interest payments.
(11/n)
This ratio determines how easy/difficult it would be for a company to service its interest payments.
(11/n)
Interest coverage ratio = [EBIT/Interest expense]
[Rs 0.35 crore/Rs 0.05 crore] = 7
There’s decent margin of safety considering your biz is generating 35 lakh EBIT before interest cost of Rs 5 lakh
(12/n)
[Rs 0.35 crore/Rs 0.05 crore] = 7
There’s decent margin of safety considering your biz is generating 35 lakh EBIT before interest cost of Rs 5 lakh
(12/n)
Had your business been generating EBIT of only Rs 10 lakh, a downturn may impact your ability to service interest and debt repayment obligations.
Hope this thread will help you analyse the companies you are tracking better
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Hope this thread will help you analyse the companies you are tracking better
(end)
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