Ratio Analysis Fundamentals in Finance | Dr. Anil Lamba

Summary

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Takeaways

• 😀 Ratios are a comparison between two numerical values, which help in putting data in perspective, especially when comparing unequal entities.
• 😀 Absolute analysis gives raw numbers, but ratio analysis helps to understand the context and significance of those numbers in relation to each other.
• 😀 Ratios help compare companies that may have vastly different scales (e.g., China vs. Belgium's GDP), providing insights like per capita GDP.
• 😀 Different ratios serve different purposes: profitability ratios (profit vs. sales), stability ratios (financial health), and efficiency ratios (turnover).
• 😀 Profitability ratios are derived from the profit and loss (P&L) account, and stability ratios are based on the balance sheet.
• 😀 Ratio analysis should be performed both intercompany (against competitors) and intracomany (year-over-year) to measure progress and identify trends.
• 😀 Gross profit ratio shows how much of the sales is turned into gross profit. A 25% gross profit ratio indicates a 25% return on sales after costs of sales.
• 😀 If gross profit increases slower than sales, it can signal issues like rising costs or inability to pass on price increases to customers.
• 😀 Net profit ratio may not always reflect efficiency due to fixed costs. A jump in net profit may come from leverage effects rather than operational improvements.
• 😀 The semi-bottom line (operating profit) is more crucial than the bottom line (net profit) for assessing the health of a business. The operating ratio is calculated by dividing operating expenses by sales.

Q & A

What is the difference between a number comparison and a ratio?

A number comparison simply lists two values, like '200 crores' and '50 crores.' However, a ratio expresses this relationship as a proportion, such as '4:1'. Ratios help put data in perspective by comparing values in a meaningful way.

Why is ratio analysis considered superior to absolute analysis?

Ratio analysis is superior because it provides a clearer comparison between unequal values, offering context. For example, comparing two companies with different sales figures is more insightful when expressed as ratios, such as '4:1', rather than just looking at the absolute numbers.

What is the significance of using ratios when comparing companies like China and Belgium?

Ratios like per capita GDP help put things in perspective. Despite China having a much larger GDP, Belgium's per capita GDP is significantly higher. Ratios allow for fairer comparisons, especially between economies or companies of vastly different sizes.

How do different types of ratios serve specific objectives in analysis?

Different ratios serve different purposes: profitability ratios evaluate a company's ability to generate profit, financial ratios assess its stability, and efficiency ratios measure how well it uses its assets. The type of ratio you use depends on the specific aspect you want to analyze.

Where does the data for profitability ratios come from?

The data for profitability ratios comes from the Profit & Loss (P&L) statement, which provides information on revenue, cost of sales, and profits.

What is the formula for the gross profit ratio?

The gross profit ratio is calculated as (Gross Profit / Sales) * 100. For example, if gross profit is 30 crores and sales are 120 crores, the gross profit ratio would be 25%.

How does comparing gross profit ratios across companies help in performance evaluation?

If a company's gross profit ratio is lower than industry peers, it suggests inefficiencies or issues with cost management. Conversely, if the ratio is higher, it may indicate strong profitability or cost control. Comparing ratios can provide insights into a company's competitive positioning.

Why might a company’s gross profit not double when its sales double?

If sales double but gross profit doesn't increase proportionally, it may indicate that the cost of sales has increased disproportionately. This could be due to higher supplier costs, poor pricing strategies, or an inability to negotiate better terms with suppliers.

What is the importance of operating profit versus net profit?

Operating profit reflects a company's ability to generate income from its core business activities. Net profit includes all income and expenses, including non-operating items. While net profit is crucial, operating profit is often considered more important as it provides a clearer picture of a company's core operational efficiency.

What is the operating ratio, and how is it calculated?

The operating ratio is calculated as (Operating Expenses / Sales) * 100. It measures the proportion of sales that is consumed by operating expenses. A lower operating ratio indicates higher efficiency in controlling operating costs.