Why ratios
Financial statements carry critical information, but a number on its own may mean little until juxtaposed with other data. Bharti Airtel earned operating profit (EBIT) of Rs 47.62 billion in FY2019, which looks large. Against revenue of Rs 807.8 billion it is relatively very small, and against interest expense of over Rs 110 billion it is clearly inadequate even to service the interest. Comparing a line item with a related data point gives better insight than reading it alone: that is ratio analysis, expressing one financial statement line item as a percentage or multiple of another related item.
Descriptive studies add perspective: saying Bharti's operating profit is 5.8% of revenue gives a sense of proportion that Rs 47 billion alone does not. Diagnostic studies explain what worked or failed: Bharti's revenue fell about 2% while EBITDA fell about 14%, and computing every expense as a percentage of revenue shows that network operating expense as a share of sales rose significantly and moved independently of sales. Predictive analysis studies the behaviour of data to assess the future.
Revenue growth negative 2.19%; EBITDA growth negative 13.9%. Expenses as a percentage of revenue: network operating expense 23.8% to 27.6%; access charges 10.9% to 11.5%; licence fee and spectrum charges 9.1% to 8.6%; employee benefit expenses 4.8% to 4.7%; sales and marketing 5.5% to 5.1%; other expenses 9.3% to 10.3%. Most items stayed more or less constant as a share of sales, barring a few basis points, so they are likely to move with sales. Network operating expenses rose sharply as a share when sales declined, which indicates they are largely fixed in nature and independent of sales. Two years of data is inadequate for a thorough study; a larger data set raises confidence, but even this initial assessment allows a rudimentary expense forecast once next year's revenue is estimated.
Analysts compute different ratios depending on the company and the objective, and often study non-financial operating metrics such as capacity utilisation or occupancy rate. The one rule is that the two numbers compared must be related in some way; unrelated numbers give little or no insight.
Profitability ratios
Profitability ratios show how profitable operations are per rupee of sales. A competitive industry with pricing pressure hurts profitability; a unique business with significant entry barriers, or an early entrant in a sunrise industry, earns high profitability, but very high levels do not last: new entrants and competition bring revenues and profits down to moderate levels. Profitability can be evaluated at each level of the P&L. The two main parameters are EBITDA margin and net profit margin (PAT margin); EBIT margin, popularly called operating profit margin, is sometimes evaluated; for valuation, NOPAT margin, net operating margin after tax, is EBIT x (1 minus tax rate).
EBITDA margin = EBITDA / Net sales
- Profitability purely from operations and direct costs, excluding the non-cash recovery of capital through depreciation and amortisation.
- A higher margin than peers indicates greater efficiency. Useful for gross profitability trends in an industry because it is unaffected by depreciation policies, funding decisions and tax rates.
- Bharti FY2019: 2,61,101 / 8,10,714 = 32.2%, approximately 440 basis points below 36.6% in FY2018.
PAT margin = PAT / Net sales
- Shareholders are paid last, after every stakeholder including the government; this shows how much of the business generated is left for them.
- A higher ratio means more efficient management of direct costs, asset utilisation and financing; a rising trend means improving profitability.
- Bharti FY2019: 16,875 / 8,10,714 = 2.1%.
Return ratios
Profitability ratios say nothing about the productivity of each rupee invested. Return ratios relate profits to the capital employed: return on equity and return on capital employed.
ROE = PAT / Net worth
- The single most important parameter for an equity investor to start digging into a company; it shows how a business allocates capital and generates return. Also called return on net worth (RoNW). Higher is better.
- Net worth = equity share capital at face value + reserves and surplus as shown in the balance sheet.
- Sales and profit are for a period while net worth is at a date, so use the average net worth: the average of opening and closing balances, the opening balance being last year's closing.
- Bharti FY2019: average net worth (8,49,486 + 7,83,483) / 2 = 8,16,485; ROE = 16,875 / 8,16,485 = 2.1%.
ROCE = EBIT / Capital employed
- Capital employed = total assets minus non-interest-bearing current liabilities, or total book value of equity plus total book value of debt. The numerator is earnings for both debt and equity holders before compensating either, so the denominator includes every capital provider being paid dividend or interest.
- Higher is better; useful for comparing companies of different sizes in the same industry. Balance sheet items are averaged.
- Bharti: total capital = total equity (7,83,483 and 8,49,480) + long-term borrowings (8,49,420 and 8,72,454) + short-term borrowings (1,29,569 and 3,10,097) + current maturities of long-term borrowings (1,34,346 and 71,732) = 18,96,818 in FY2018 and 21,03,763 in FY2019; ROCE = 47,626 / average = 2.38%. This is pre-tax; multiply by (1 minus tax rate) for the post-tax return. Versions of ROCE vary across the industry, for instance to remove the effect of negative working capital in consumer businesses.
The sample question gives P/E 10, P/B 5, book value per share Rs 15 and 10,000 shares. Price = 5 x 15 = 75; EPS = 75 / 10 = 7.5; ROE = EPS / BVPS = 7.5 / 15 = 50%. Equivalently ROE = P/B divided by P/E. The share count is a distraction.
When a question supplies opening and closing net worth or capital, the syllabus method averages them. When it supplies only a closing figure, use it and note the approximation. Mixing a period flow with a point balance without averaging is the error the syllabus warns about.
- Bharti Airtel's EBIT of Rs 47.62 billion looks large until set against revenue of Rs 807.8 billion (5.8%) and interest of over Rs 110 billion, which it could not even cover. Ratio analysis expresses one line item as a percentage or multiple of a related one; the two numbers must be related, and non-financial metrics like capacity utilisation or occupancy are studied too.
- Three purposes: descriptive (sense of proportion), diagnostic (why EBITDA fell 13.9% on a 2.19% revenue decline: network operating expense rose from 23.8% to 27.6% of revenue while other expense ratios stayed within a few basis points), and predictive (expenses constant as a share of sales move with sales; network costs behave as fixed, so a rudimentary forecast follows from a revenue estimate, though two years of data is inadequate).
- Profitability per rupee of sales: EBITDA margin = EBITDA / net sales, unaffected by depreciation policy, funding and tax, useful for gross profitability trends (Bharti 32.2%, about 440 bps below 36.6%); PAT margin = PAT / net sales, what is left for shareholders (2.1%); EBIT margin is operating profit margin; NOPAT margin = EBIT x (1 minus tax rate) for valuation. Very high profitability attracts entrants and moderates.
- Return on capital: ROE = PAT / net worth, the single most important starting parameter for an equity investor, with net worth = equity share capital at face value + reserves and surplus, using the average of opening and closing balances (Bharti 16,875 / 8,16,485 = 2.1%). ROCE = EBIT / capital employed, where capital employed = total assets minus non-interest-bearing current liabilities, or book equity plus book debt, again averaged (Bharti 2.38%, pre-tax; multiply by 1 minus tax rate for post-tax); it compares companies of different sizes in one industry.