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Foundations

Fundas : Understanding Financial Ratios – Part 1

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One of the most important task that a fundamental analyst undertakes while analyzing companies is going through and understanding the financial statements of companies – Balance Sheet, Profit and Loss and Cash Flow Statements.

One of the effective ways of interpreting the numbers posted in the financial statements is  a) preparing and b) understanding financial ratios. The source for preparing financial ratios are the three financial statements stated above.

Basically financial ratios answer questions like how efficient is the company in managing its assets? Is the company managing its debts and is it able to comfortably make its interest payments? Does the company earn more than its cost of capital, is the company cheap/expensive compared to the profits that it generates among other questions. These questions are answered in the form of numbers and hence it is very important to understand and interpret these numbers.

However it is important to note that the values that are arrived at cannot be seen in isolation, for instance the operating margins for Asian Paints in FY18 were 17%, is this good or bad? To answer this questions one needs to a) look at trend in operating margins of Asian Paints over longer period of times (5-10 years) and b) look at the operating margins of other companies like Berger, Akzo Nobel and Kansai Nerolac. Hence value of any ratio in a particular year will not help in analyzing the company. The analyst needs to look at the trend in those ratios over longer periods of time and compare it with the other players in the Industry.

Ratios Classification

There are no guidelines or framework to classify ratios. We will broadly classify ratios under the below heads and cover important ratios that investors need to look at under each of them. In this post we will cover activity or operating ratios.

  • Activity or Operating
  • Leverage
  • Profitability
  • Valuation

Activity or operating ratios measure the efficiency with which the company manages its assets in its day to day operations. Assets which generate revenues for the company are fixed and working capital assets. Hence we will cover ratios which will highlight how companies fare in managing these assets.

Leverage ratios indicate if the company is able to meet its short and long term obligations

Profitability ratios look at how profitable the company is at various levels – gross, operating (EBIT) and net profit. It also looks at whether the company is able to generate satisfactory (returns greater than cost of capital) returns on its assets and what return a common shareholder can expect by investing in the company

A great business needs to be bought at the right price and valuation ratios to a certain extent help investors in ascertaining if the price that they are paying for acquiring the security is right.

Operating Ratios

Some of the operating ratios that we will look at in detail in this post are as below

  • Inventory turnover
  • Inventory days
  • Receivable turnover
  • Receivable days
  • Payable turnover
  • Payable days
  • Working capital turnover
  • Fixed asset turnover
  • Total asset turnover

Inventory turnover

Firstly, let us see how the inventory ratio is calculated

                                    Inventory turnover ratio = Cost of goods sold (COGS) / Average Inventory

The ratio indicates the no of times the company sells or replenish its inventory in a given period. COGS which is the numerator in the above formula is taken from the P&L and is taken because it is the cost that goes into making the final product. The denominator is taken from the balance sheet and is the average number for two financial years.

Let us explain this further with a help of an example

Below are consolidated figures of the related items from the annual report of Asian Paints for FY18. All figures in Rs Cr

Fundas : Understanding Financial Ratios - Part 1
While calculating the COGS we also look at some items that are recorded in the other expenses line item. These items are consumption of stores and spares and power and fuel expenses. These expenses should also be taken to arrive at the COGS as these pertain to manufacturing the final product. These amount to Rs 142 Cr in the case of Asian Paints for FY18,
Fundas : Understanding Financial Ratios - Part 1

The total COGS for Asian Paints at the end of FY18 is as below

                                           COGS = 8585+964+142+48+94

This works out to Rs 9833 Cr. The average inventory is Rs 2642 Cr.

Fundas : Understanding Financial Ratios - Part 1

The inventory turnover for Asian Paints is 9833/2642 = 3.72 times. This means that Asian Paints sold its inventory 3.72 times in a year or roughly once every 3.2 months.

Inventory days is calculated as

                                   Inventory days = Number of days in a period/Inventory turnover ratio 

The number of days in a period is taken as 365, as we are calculating the ratio for the whole year. We have already arrived at the inventory turnover ratio earlier. The Inventory days for Asian Paints is 98 days.

                                                         Inventory days = 365/3.72

This indicates the number of days it takes Asian Paints to convert its inventory into sales. One can observe that higher the inventory turnover ratio the lower are the inventory days. For instance if the inventory turnover ratio for a company is 12, meaning it sells its inventory 12 times in a year the inventory days will be 30 (365/12). One needs to investigate and compare this number of the company with that of its peers in the industry. It may be a case where higher inventory turnover leading to lower inventory days may be because the company is unable to meet the demand in the market or lower inventory turnover leading to higher inventory days may be because the companies products are not selling in the market or it is stocking up on inventory and expects to sell this going forward. Hence it is very important to understand how the business is also progressing to understand these numbers.

Receivable Turnover

The receivable turnover ratio is calculated as 

                                      Receivable turnover ratio = Sales / Average receivables

This ratio indicates the number of times a company collects cash from its customers in a given period. Let us check the number for Asian Paints – the company recorded sales of Rs 17,262 Cr during the year and its average receivables were Rs 1589 Cr. The receivable turnover ratio for Asian Paints is 10.86. This also implies that the company collects cash from its customers roughly every month.

                                              Receivable turnover ratio = 17262/1589

Receivable days are calculated as

                                 Receivable days = Number of days in a period / Receivable turnover 

In the case of Asian Paints the receivable days are 33, meaning the company collects cash from its customers once every 33 days.

                                                       Receivable days = 365/10.86

The lower the receivable days the better, however at the cost of repeating ourselves, we would like to reiterate that it needs to be checked as to why the company collects cash from its customers so quickly. In the case of Asian Paints the company through its strong distribution network supplies products to its customers at a short notice. The benefit of this is that the dealer, who is the customer of Asian Paints does not have to stock paints at his store/warehouse. It is also a leader in the paint segment and that goodwill also helps in collecting cash faster.

Payable Turnover

The payable turnover ratio is calculated as

                                          Payable turnover ratio = Purchases / Average Payables

One can calculate the purchases that the company makes during the year as below

                                       Purchases = COGS + Ending Inventory – Beginning Inventory

One can also use COGS in the numerator instead of purchases while computing this ratio.

This ratio indicates the number of times a company pays its suppliers or creditors for the raw material that they supply during a given period.

Let us look at payable turnover ratio for Asian Paints

We will first calculate the purchases of the company for the year, COGS will include the below three items recorded in the profit and loss

Fundas : Understanding Financial Ratios - Part 1

Purchases that the company made during the year were Rs 9723 Cr

                                               Purchases = 9691 + 2658 – 2626

Average payables stood at Rs 2041 Crs, hence the payable turnover for the company was 4.76. This means that the company made payments to its suppliers 4.76 times in a year or roughly every 2.5 months.

Payable days are calculated as

                             Payable days = Number of days in a period / Payable turnover

Payable days for Asian Paints is 77 days. This means that the company pays its suppliers once in 77 days.

                                                  Payable days = 365/4.76

One can observe that the company receives monies from its customers in 33 days and pays its suppliers in 77 days. This can be attributed to the strong position that the company enjoys in the market. However in some other case where the payable days are higher – it may be the case that the company is unable to pay its suppliers on time.

Working Capital Turnover

The working capital turnover is calculated as

                                      Working capital turnover = Sales / Average working capital 

Working capital is the difference between current assets and current liabilities. However we will arrive at the working capital as below

                                    Working Capital = Inventories + Receivables – Payables

We use the above as the above items are the core and majority of the working capital requirement of a company. The working capital turnover ratio indicates the amount of sales a company generates for every 1 Re that it has invested in working capital.

Let us look at the working capital turnover for Asian Paints

The company generated sales of Rs 17,262 Cr and the average working capital for FY17 and FY18 is Rs 2192 Cr. The working capital turnover of the company is 8, meaning the company generates Rs 8 of sales for every 1 Re that it invests in working capital. We will have to compare this ratio of other players in the industry to ascertain if this is better or worse than the industry average. There are few companies where companies have negative working capital, in that case this ratio cannot be computed for those companies.

Fixed Asset Turnover

The fixed asset turnover is calculated as

                                          Fixed Asset Turnover = Sales / Average Net Fixed Assets 

​​​​​​​What is the sales that the company generates for every 1 Re of fixed assets that the company has in place is what this ratio answers. Fixed assets here refer to property plant and equipment (PPE), intangible assets and capital work in progress (CWIP).

Fundas : Understanding Financial Ratios - Part 1

The fixed asset turnover for the company is 4, meaning that the company generates 4 Rs of sales for every 1 Re it has invested in fixed assets.

                                                  Fixed Asset Turnover = 17262/4349

Total Asset Turnover

Total asset turnover is arrived at as below

                                             Total Asset Turnover = Sales / Average total assets

While the fixed turnover takes only fixed assets as the base, here we take into account the total assets of the company and answer the same question –  what is the sales that the company generates for every 1 Re that it has in total assets.

Total asset turnover for Asian Paints is 1.31 and is arrived at as below

                                                  Total asset turnover = 17262/13102

This ratio includes all assets on the balance sheet. There may be a case where the company will have huge amounts of financial assets – cash and other financial instruments on its books, this ratio also takes these numbers into consideration while arriving at the final value. The value arrived at in this case does not give a correct picture as cash and other financial assets are not operating assets – assets used in day to day operations of the business that generate revenues for the company. Hence one needs to look at the whole balance sheet structure to make sense of this ratio or use working capital and fixed asset turnover ratios separately to measure how efficiently the company is managing its assets.

Putting It Together : Operating Efficiencies of Paint Companies

We looked at the above ratios for four paint companies listed on the exchanges – Asian Paints, Berger Paints, Kansai Neroloc and Akzo Nobel. There are three more companies that are listed, however they are small companies and we haven’t taken them into consideration. Below are our findings

Fundas : Understanding Financial Ratios - Part 1

Inventory turnover for Akzo Nobel is the highest resulting in low inventory days, it is able to convert its inventories into sales in 86 days, all other players have higher inventory days. One needs to check the trend in this number for Akzo and also ascertain as to how it is able do so.

Asian Paints scores over its peers in collecting cash faster than any other player in the market. Asian Paints receivable days at 35 are at the lowest in the industry. We had explained the possible reason for the same while explaining the receivable turnover ratio earlier in the post.

Akzo Noble pays its suppliers in 146 days, where as Asian Paints does it 76 days. As a supplier personally one would like to do business with Asian Paints as they pay you the fastest amongst all the players in the industry. One would need to investigate the payable days of Akzo Nobel as they are way off from the other players in the industry. Some questions that will need to be asked in this case would be – Is this sustainable?, Is the company finding it difficult to pay its suppliers? What is the trend in Akzo’s payable days over longer periods of time. If the company is taking 5 months to pay suppliers it may face a situation in the future where suppliers will be unwilling to supply raw materials to the company.

Akzo Nobel working capital turnover is the highest at 17 and way higher than the other players in the market.The primary reason for the same is the high payable days of the company.

Berger and Akzo have the highest fixed asset turnover at 4.9, meaning they generate nearly 5 Rs of sales for every 1 Re they have in fixed assets. One can see that the fixed asset turnover of Asian Paints is 4, however if one were to look at the long term trend below – this ratio is at the lower band. Possible reason could be that the company has taken up CAPEX and sales are yet to kick in from the investments that have been incurred.

Fundas : Understanding Financial Ratios - Part 1
Fundas : Understanding Financial Ratios - Part 1

The above numbers are only for FY18, it is highly recommended that this exercise is carried out for all companies in the industry for long periods of time.

Final Thoughts

Managing operations of the business has repercussions on other aspects of the business as well. For instance if the company is not able to manage its working capital efficiently that could impact the cash flow generating capacity of the company, generating inadequate cash flows from the business will impact the company in investing in newer assets and the company will be forced to taken on debt to fill in the short fall. Hence it is very important for the management to be laser focussed on running their operations effectively and efficiently.

We hope that readers will have a better grip on operating ratios after reading this post. We will cover other ratios in our next post.


NOTE: Please do not consider this article as a recommendation, It is purely for informative purpose only. Authors may have positions in the stocks mentioned, so consider our analysis biased. There is no commercial relationship between Capitalmind and the companies mentioned in this analysis.

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