When you get the balance sheet of 2 companies that you want to compare the first thing you do is to make sure that both are in the same language! So if you are comparing Toyota Motors, Form Motors and Tata Motors – you need to bring them all to US $, and then start comparing.

Also it is unfair to compare companies of different sizes, because it makes no sense. So you will have to bring them to “same size” by converting all the numbers to a %age. Then you will be able to compare the same. That, is the starting point.

Another thing you can do is to compare the ratios. Ratios of course have no units – the units in the numerator cancel the units in the denominator! You may have heard of words like “P/E ratio,” “current ratio” and “operating margin.” In fact you cannot miss them if you are a TV watcher or a pink paper reader. However, what do these terms mean and why can you not find them in the annual reports?  Here are some of the many ratios that investors calculate (should calculate?) from information on financial statements and then use to evaluate a company. When you are looking at different industries or at different aspects in the same company you use different ratios.

Companies have ratios split into

a) balance sheet ratios

b) Profit and Loss ratios

c) solvency ratios  and d) activity ratios

Ratios are used not only to compare across companies, but also across the same company for different points in time. So a Q1 can be compared to Q2 or Q1 to the total for the year….as you wish

If a company has say a Debt:Equity ratio of 2:1 it means it has Rs. 2 of borrowing for every rupee that it owns. What is owns is what we called ‘shareholder’s funds’ – it is the capital that the shareholders put, the premium, and the undistributed profits. Borrowing is the total money that it owes outsiders.

Inventory Turnover Ratio = Cost of Sales / Average Inventory for the Period

If a company has an inventory turnover ratio of 2 to 1, it means that the company’s inventory turned over twice in the reporting period. Obviously it will be different for each industry. A very capital intensive business like say making big Engines will have a much lower number than say your neighborhood sandwich seller. So you should know the ‘norms’ of the industry before you start comparing from one company to another.

Operating Margin = Income from Operations / Net Revenues

Operating margin is usually expressed as a percentage. It shows, for every rupee of sales, what percentage was profit. This could be done at various levels and the numerator changes accordingly. The numerator could be Gross profit, Net profit, Ebidta, -depending on what level of profitability you are comparing.

P/E Ratio = Price per share / Earnings per share

If a company’s share is selling at Rs 20 per share and the company is earning Rs. 2 per share, then the company’s P/E Ratio is 10 to 1. The company’s stock is selling at 10 times its earnings. PE ratio is easy to calculate but very difficult to understand, implement, and use!

Working Capital = Current Assets – Current Liabilities

This shows how much of the company’s assets are in the ‘working capital’ or ‘current status’. The aim is to keep reducing the amount of working capital that you use, so that the overall profitability goes up.

  • Debt-to-equity ratio compares a company’s total debt to shareholders’ equity. Both of these numbers can be found on a company’s balance sheet. To calculate debt-to-equity ratio, you divide a company’s total liabilities by its shareholder equity, or
  • Inventory turnover ratio compares a company’s cost of sales on its income statement with its average inventory balance for the period.
  • Operating margin compares a company’s operating income to net revenues. Both of these numbers can be found on a company’s profit and loss account.
  • P/E ratio compares a company’s share price with its earnings per share. To calculate a company’s P/E ratio, you divide a company’s share price by its earnings per share, or
  • Working capital is the money leftover if a company paid its current liabilities (that is, its debts due within one-year of the date of the balance sheet) from its current assets.

This was just a glimpse……tons of work to be done in understanding Financial ratios. Go pick up a book on Finance….

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