Understanding Financial Numbers

Result season is here with lot of data. Market enthusiasts are keeping an eye on the numbers, vying to get the best of the deals. This season has seen a lot of variation with companies like ITC booking more than expected profits, L&T meeting expectations and then some like TISCO with a disappointing show.

Some good parameters to assess Company’s financial health other than PE are:
1. Quick ratio: Quick Ratio is often used as a better test of a company's liquidity position. That is why it is some times called a Liquidity Ratio or Acid Test Ratio.

The Quick Ratio is obtained by subtracting inventories from the Current Assets figure, before dividing by the Current Liabilities.

Quick ratio = (Current assets – Inventories) / Current Liabilities

A ratio of 1.0 is considered good enough. It can be higher for certain industries, but too high a ratio may indicate management inefficiency.

2. Current Ratio: The Current Ratio indicates whether the company will be able to meet its payment obligations that become due within the year. It can do this by using the cash, or by collecting payments from its debtors, or by quickly turning over inventory to generate cash.

This ratio is obtained by dividing the Current Assets figure in the Balance Sheet by the Current Liabilities. A good ratio is between 1.5 and 2. A ratio of 3 or more may not necessarily be better.

Current Ratio = Current assets / Current Liabilities

Current Assets typically comprise: inventories, cash and cash equivalents, accounts receivables (debtors), loans and advances.

Current Liabilities include: interest payments, accounts payables (creditors), provisions for payments of taxes, dividends, retirement and other benefits.

3. Debt/Equity ratio: This ratio measures how much money a company can borrow over the long term without running into payment problems. When a company keeps borrowing, its fixed costs keep increasing due to the interest payments.

Debt/Equity ratio = Total debt / Shareholder's equity

Total debt includes both short term and long term debt, such as, secured and unsecured loans, mortgage payments. Shareholder's equity includes equity shares and reserves.

Ideally Debt/Equity ratio should be less than 1, and the lower the better. But this is a thumb-rule. For certain industries like auto manufacturing, the ratio can be 2 or more. One needs to make peer comparison in a sector or industry to arrive at typical ratios. Given a choice, I'd prefer a company with high equity than one with high debt. Why? There are no fixed costs involved with equity shares. If business is good, more dividend payout may be involved. If business is bad, dividend payment can be slashed. Interest payments due to high debt will need to be paid regardless.