FAQs on ratios & measures used to analyse fundamentals of a company
1. What are the key debt ratios used to evaluate a company?
Debt ratios are used to evaluate the riskiness of a company. The main debt ratio used to evaluate a company is the debt-to-equity ratio. While some companies may not have debt and this would render this ratio meaningless for evaluation, risky companies in the manufacturing sector may have relatively high debt-to-equity ratios. Another measure of the ability of a company is the interest coverage ratio, which represents the ratio of operating income to the interest expense of a company.
2. What are the measures that evaluate the liquidity position of a company?
Some of the ratios that evaluate the liquidity of the company include the liquid ratio, which is the ratio of current assets to current liabilities of the company. Apart from this, the other measure is the quick ratio, which excludes the effect of stock/inventory while comparing the assets with the liabilities of the company. Other measures that evaluate the liquidity position include the cash conversion cycle, which estimates the number of days that it takes to convert its investments in inventory as well as other resources into cash flow from sales. It is also called the net operating cycle. The cash conversion cycle is calculated as inventory days outstanding plus days sales outstanding less days payable outstanding.
3. What are the profitability measures while evaluating the performance of a company?
The profitability measures of a company include profit margin ratios such as the gross profit margin, EBITDA margin, operating margins, and net profit margins. Other profitability measures include return ratios such as return on equity, return on assets (important while analysing banks & NBFCs), return on capital employed, etc. The important thing for investors is to assess the trend in these measures over time. In most cases, investors compare the latest measure or ratio with the 3 or 5-year trend to get an idea about how the company is positioned within the business cycle.
4. Define DuPont analysis. How does operating efficiency impact DuPont analysis?
DuPont analysis is a technique used to decompose the drivers of the return on equity of a company. It was first used by DuPont Company in the US. In its simplest form, DuPont analysis is the net profit margin multiplied by the asset turnover ratio multiplied by the equity multiplier. While the net profit margin captures the industry environment, in which the company is operating, the asset turnover ratio captures the efficiency in the utilisation of the average assets of the company (the formula for asset turnover is sales divided by average total assets). The equity multiplier captures the extent to which debt is being used to fund the total assets of the company (the formula for equity multiplier is average total assets divided by average shareholders' equity).