Become An Expert on Financial Ratios

The analysis of financial ratios is the best way to analyze financial statements. The father of fundamental analysis “Benjamin Graham” made the financial analysis theory popular. Interpreting of results, comparison with previous years, and comparison with the other companies in the same sector can be done through analysis of financial ratios. The data for financial analysis is taken from financial statements.  The information conveys from the financial ratio of a company is not enough. For example, ICICI bank has a profit margin of 12 percent, this data is not of any use until we compare it with the other counterpart like HDFC bank. There are mainly four types of financial ratios namely profitability ratios, leverage ratios, valuation ratios, and operating ratios. We will discuss about profitability ratios in this article.

Profitability Ratios:

The profitability of the company is analyzed with the help of profitability ratios. The analysis of profitability ratios is done to conclude the performance of the profit-generating capability of the company. Management competitiveness can also be seen in this ratio as the profits are needed to pay the dividend and business expansion.

We will discuss the following ratios under the profitability ratios- EBITDA Margin, PAT Margin, Return on Equity, Return on Asset, and Return on Capital Employed.

EBITDA Margin:

The Earnings before Interest Tax Depreciation & Amortization (EBITDA) Margin shows the efficiency of the management. EBITDA Margin indicates how profitable the company is at an operating level in percentage terms. EBITDA margins are mainly compared with the company versus its competitor to get a sense of the management’s efficiency in terms of managing their expenses.

First, we calculate EBITDA in order to calculate the EBITDA margin.

EBITDA = [Operating Revenues – Operating Expense]

Operating Revenues = [Total Revenue – Other Income]

Operating Expense = [Total Expense – Finance Cost – Depreciation & Amortization]

EBIDTA Margin = EBITDA / [Total Revenue – Other Income]

Profit After Tax (PAT Margin): The EBITDA margins are calculated at the operating level however, the Profit After Tax (PAT) margins are calculated at the final profitability level. When the PAT margin is calculated, all expenses are deducted from the Total Revenues of the company to identify the overall profitability of the company.

PAT Margin = PAT/Total Revenues

Return on Equity (ROE): The Return on Equity (RoE) helps the investor assess the return the shareholder earns for every unit of capital invested. It measures the ability of the entity to generate profit from the investment of shareholders. So it can be concluded that the higher the ROE the better it is for shareholders. The top Indian companies have the ROE of 14 to 16 percent however, the ROE of other companies in the same Industry also considered for rational decision.  A high ROE and high debt is not a good sign for the company.

ROE = Net Profit / Shareholders Equity* 100

Return on Asset (ROA):

Return on Asset shows the effectiveness of the entity’s ability to utilize the assets to generate profits. The efficiency of deploying assets of the entity is indicated in ROA. Higher ROA is better for the entity.

RoA = [Net income + interest*(1-tax rate)] / Total Average Assets

Return on Capital Employed:

The Return on Capital employed shows the profitability of the company taking into consideration the overall capital it employs. Long term and short term equity and debt both are included in capital employed.

ROCE = [Profit before Interest & Taxes / Overall Capital Employed]

Overall Capital Employed = Short term Debt + Long term Debt + Equity

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