Chapter 17 – Key ratios

Now that we know how to read balance sheet and income statement, let’s go through some of the key numbers and ratios that help us in studying the financial health of a company. This is going to be a big read, so brace yourself!

EPS (Earnings per share): This number shows the total earnings per share of the company. We did see the trends in Net profit over the years earlier, so how is this number useful? The company could have issued more stock during the years which would lead to reduction in earnings available for each shareholder. Whilst issuing more shares (hence more capital) is not a bad thing in itself, it should not come at the cost of existing shareholders. If the company issues shares for mismanagement of capital rather than expansion, it is a red flag for any investor. (E.g. If you see large amount of debt and income not being able to support the interest payments, chances are that it will either issue even more debt or shares to get out of the trouble). While calculating the EPS, we should always include the stock options available for employees. EPS is expressed as below:

Net profit/(Total outstanding shares + Stock options)

A positive trend of EPS over the years is a good sign of earning power of a company.


Return on Equity (RoE): Whenever we invest our capital in any stock/property/bonds/Fixed deposits, we look at what we earned. Instead of looking at the absolute return, we should look at the percentage earned for the whole capital invested to figure out if we are making good money. E.g. if you invest $100k in bonds yielding 3% coupon, you get $3k in one year. It is not the same as earning $3k on $20k investment in equities, right? That is because the second option gives you a more capital efficient method to make money. Earning 3% on bonds vs 15% on stocks for the same absolute return, but with lower capital (numbers are made up for concept basis).

Evaluating various businesses is the same as evaluating our personal investments. Checking the return on equity over the years gives us a good sense of whether the business is becoming more efficient or more productive. When we check this parameter across various companies in the same industry, it is more likely to help us pick up a quality business for our investment. This is calculated as below:

RoE (%) = Net income/Shareholders’ equity

Return on Capital Invested (ROIC): This parameter is very similar to RoE, except that we include the debt as well. As long as this number is higher than the cost of debt, we can be assured that business is making more than the cost of borrowing the money, hence adding to shareholder’s income (as was shown in previous chapter on Leverage). This is calculated as below:

ROIC (%) = Net income/(Shareholders’ equity + Total Debt – Cash)

The reason we deduct cash is that it can be used to pay off some portion of the debt. If this cash is not actively used in business activities of the company, it means that the management is still trying to find better investment opportunities. If they do not find such investment opportunities, they’d be better off paying off some debt or returning the cash to the shareholders in form of dividends or share buybacks.

LEVERAGE PARAMETERS: Debt/Equity and Interest coverage

From the previous chapter, we saw that leverage can be a powerful tool, but can be very harmful in bad business conditions. I’ll now give a brief on couple of ratios that can alarm us or make us comfortable about an investment opportunity.

Leverage (Debt/Equity): The ratio shows us the proportion of debt and shareholders’ equity in financing the business activities. We do not want this ratio to go higher than 1, i.e. the company should ideally not borrow more than what the owners have invested and accumulated over the years. That said, we should realise that some businesses require higher fixed capital like utilities/telecom etc., so those companies may have higher Debt/Equity ratio. In these cases, it is more prudent to understand the earning power of the companies and estimate if they could be in a potential problem. I tend to stay away from such companies (Debt/Equity > 1) since I believe we can always find good opportunities in companies with healthier financials.

Interest coverage ratio (EBIT/Interest expense): This ratio shows us whether the company is earning enough to meet the interest payments every year. If this ratio is lower than 1, it means that the company is not earning enough to pay the interest on its debt. This is definitely indicative of a business in trouble.

To calculate any of the numbers involving income, we should always exclude the extraordinary income (income not generated from operating activities). Extraordinary income could be in the form of a sale of assets or reversal of some reserves or a court settlement or any such reason which can not be directly attributed to normal business scenario. Please do note that the managements are well aware of the fact that the investors look at headline numbers like EBIT or Net income. Since investor confidence (and hence their compensation) is generally based on these numbers, management at some companies can be very enterprising in showing that the numbers are healthy but the facts could indicate otherwise. Hence, we should always look at the financial disclosure ourselves.

Chapter 18 – Cash flow statement (1)

Chapter 16 – Leverage

Chapter 16 – Leverage

Leverage basically refers to borrowing money at cheaper rate to invest in assets with higher rate of return, thus resulting in a profit. If the business conditions stay good, this can result in a good profitable situation for the business owners. However, if the investment turns out bad, it might end up in a result which is not so good from an owner’s point of view. Let’s run through two scenarios for the hot dog owner:

Scenario 1 (with debt): The hot dog owner has $50,000 to start his business. Let’s say he borrows another $50,000 @ 10% per year (i.e. an interest expense of $5,000 per year) to setup the business in double the size since he believes that there is a good opportunity to earn more money by setting up 2 shops. Assume both shops are setup in two malls with similar footfall i.e. similar number of customers visiting every year. Assume cost of goods sold and SG&A to be constant at $40,000 per shop. Assume profits to be taxed at 25%.

Case 1: Business is great and both shops make $70,000 per year

Case 2: Business is not so great, a new pizza chain opens shops right next to both hot dog shops and kills the sales. So the total revenues are now $80,000 ($40,000 per shop).

Scenario 2 (without debt): Here, the hot dog owner opens only one shop with his equity of $50,000. Assume cost of goods sold and SG&A to be constant at $40,000 per shop. Assume profits to be taxed at 25%.

Case 1: Business is great, shop makes $70,000 per year

Case 2: Competition from pizza shop drives the revenues down to $40,000 per year

In the above examples, we have made the numbers such that the Case 1 for both Scenarios show a jolly picture of business while Case 2 shows the worst case scenario for the business. Let’s try and understand the economics of leverage now:Leverage, debt, return on equity, financial analysis

As you can see, when the business is doing well, taking some loan actually increased the amount of net income available for hot dog owner. His return on equity increased from 45% to 82.5%. So leverage can amplify returns in good times. However, take a look at the scenario when business is not doing well. Without debt, the business makes no profit. But with debt, the hot dog owner has to pay interest on top of the expenses, leading to a net loss. So the net return on equity worsens from 0% to -10%.

Hence, it is always good to analyze the amount of debt carried by a company. There have been instances where the companies used a lot of leverage and could not pay back the loans resulting in creditors taking control of the assets and liquidating the business, thus leaving nothing for the owners.

Chapter 17 – Key ratios

Chapter 15 – Shareholders’ equity

Chapter 14 – Long term debt and other liabilities

Long term debt: Money borrowed by a company for more than one year is called long term debt. The reasons to issue long term debt could be either of the following:

  • Funding long term assets: When the company has to setup factories and other infrastructure which has a certain cost and can’t be repaid in one year’s time from the yearly operations, the company borrows money for a longer term so that it can pay off the debt in small intervals (much like the house loans taken by individuals which they expect to pay off in coming years from the income).
  • Funding acquisitions: When a company wants to buy out another company but doesn’t have enough capital to do it on its own, it borrows money from the market to acquire another company and pays off the debt in small steps using the cash flows from the business of existing operations and the acquired company.
  • Leveraging the business for higher returns: It is important that we talk about the concept of leverage and how it can increase the returns for a business owner or even have a negative impact on the financial position. This concept applies to overall debt (short term debt + long term debt) and will be discussed in the chapter after we learn about Shareholders’ equity.

Other non-current liabilities are usually not significant to spend time on. These may relate to some taxes to be paid or other obligations.

Chapter 15: Shareholders’ equity

Chapter 13: Current ratio