Ratio analysis is a mathematical tool that enables us to gauge the comparative performance of a company. Ratios could be used to compare the performance of a company:
· vis-a- vis it’s competitors,
· or to judge it’s performance compared to past performance.
Before you deep dive into the world of ratio analysis it is worthwhile to emphasise on the purpose of carrying out this exercise. The purpose of ratio analysis is not to merely calculate the value of ratios. The purpose is to gauge the health of the organization through proper analysis. Hence, emphasis should be equally on both the inputs and the formula. Following are certain checks you need to carry in order to ensure that the ratios serve the purpose for which it is being computed:
· Understanding the industry and the company: Every company has a story. Numbers just help us understand the story better. Hence, when we want to narrate a story careful choice of inputs to the ratio makes sure we have the logical understanding of the story. Here are certain illustrations to drive the home better.
1 The company which has a pension liability equivalent to the market value of debt would have to account for the pension liability value in calculating Enterprise Value (EV), for any of the EV ratios.
2 If a company has historically, been sitting on huge piles of cash it would be prudent to net out excess cash while calculating Net Working Capital.
· Consistency factor: Whenever we build a framework for analysis in the real world there are a lot of assumption that we make. However, “the logic remains fractured” if we do not make our assumptions pertaining to the numerator and denominator consistent. Here are few examples:
o Whenever we account for a Capital Lease in Return on Asset ratio we would also have to net out expenses pertaining to interest and depreciation
o Any ratio that involves both expenses (income statement item) and assets (balance sheet item ) needs to be made consistent. This is because balance sheet records an item as on date whereas income and expenditure records all entry for a period. Thus, we average the opening and closing balance sheet item to make the items comparable.
· Source of input: It takes time for an amateur to understand how the sources for the input can make a difference. The preferred source for the data generally is annual reports and conference call transcripts. However, at times we are forced to pick up data directly from the databases. When picking data from the databases it is always good to go through the definitions of the terms and remove affect of adjustments with which the analyst does not agree.
Author: Abhishek Sinha
Abhishek Sinha has approximately 8 year of experience in equity research, business research and consultancy. He has also had the privilege of managing a small portfolio of INR 3 million. However, his interest lies in teaching and "demystifying concepts." He has taught students right from the age of 3 years at PP1, to 40 years at executive courses and believes teaching is not about knowing the concepts; it is about relating the concepts to the audience. At present he is "gainfully employed" at Vignana Jyothi Institute of Management, Hyderabad; where he loves to teach finance to an enthusiastic bunch of management students. His hobbies include analyzing income statement, balance sheet and cash flow.> Google +
Hi Abhishek, very informative post; especially I liked the part on 'picking from databases;.
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