Category: Management Notes

The current ratio, also known as the working capital ratio, measures the capability of a business to meet its short-term obligations that are due within a year. The ratio considers the weight of total current assets versus total current liabilities. It indicates the financial health of a company and how it can maximize the liquidity of its current assets to settle debt and payables.  The Current Ratio formula (below) can be used to easily measure a company’s liquidity.

Current Ratio = Current Assets / Current Liabilities

What are Current Assets?

Current assets are resources that can quickly be converted into cash within a year’s time or less. They include the following:

• Cash: Legal tender bills, coins, undeposited checks from customers, checking and savings accounts, petty cash
• Cash equivalents: Corporate or government securities with 90 days or less maturity
• Marketable securities: Common stock, preferred stock, government and corporate bonds with a maturity date of 1 year or less
• Accounts receivable: Money owed to the company by customers and that is due within a year. This net value should be after deducting an allowance for doubtful accounts (bad credit)
• Notes receivable: Debt that is maturing within a year
• Other receivables: Insurance claims, employee cash advances, income tax refunds
• Inventory: Raw materials, work-in-process, finished goods, manufacturing/packaging supplies
• Office supplies: Office resources such as paper, pens, and equipment expected to be consumed within a year
• Prepaid expenses: Unexpired insurance premiums, advance payments on future purchases

 What are Current Liabilities?

Current liabilities are business obligations owed to suppliers and creditors, and other payments that are due within a year’s time. This includes:

• Notes payable: Interest and the principal portion of loans that will become due within one year
• Accounts payable or Trade payable: Credit resulting from the purchase of merchandise, raw materials, supplies, or usage of services and utilities
• Accrued expenses: Payroll taxes payable, income taxes payable, interest payable, and anything else that has been accrued for but an invoice is not received
• Deferred revenue: Revenue that the company has been paid for that will be earned in the future when the company satisfies revenue recognition requirements

 Why Use the Current Ratio Formula?

This current ratio is classed with several other financial metrics known as liquidity ratios. These ratios all assess the operations of a company in terms of how financially solid the company is in relation to its outstanding debt. Knowing the current ratio is vital in decision-making for investors, creditors, and suppliers of a company. The current ratio is an important tool in assessing the viability of their business interest.

The Debt Service Coverage Ratio (DSCR) measures the ability of a company to use its operating income to repay all its debt obligations, including repayment of principal and interest on both short-term and long-term debt. This ratio is often used when a company has any borrowings on its balance sheet such as bonds, loans, or lines of credit. It is also a commonly used ratio in a leveraged buyout transaction, to evaluate the debt capacity of the target company, along with other credit metrics such as total debt/EBITDA multiple, net debt/EBITDA multiple, interest coverage ratio, and fixed charge coverage ratio.

Debt Service coverage Ratio = EBITDA / (interest + Principle)

Debt Service coverage Ratio = (EBITDA-Capex) / (interest + Principle)

Where:

• EBITDA = Earnings Before Interest, Tax, Depreciation, and Amortization
• Principal = the total loan amount of short-term and long-term borrowings
• Interest = the interest payable on any borrowings
• Capex = Capital Expenditure

 Some companies might prefer to use the latter formula because capital expenditure is not expensed on the income statement but rather considered as an “investment”. Excluding CAPEX from EBITDA will give the company the actual amount of operating income available for debt repayment.

Interpretation of the Debt Service Coverage Ratio

A debt service coverage ratio of 1 or above indicates that a company is generating sufficient operating income to cover its annual debt and interest payments. As a general rule of thumb, an ideal ratio is 2 or higher. A ratio that high suggests that the company is capable of taking on more debt.

A ratio of less than 1 is not optimal because it reflects the company’s inability to service its current debt obligations with operating income alone. For example, a DSCR of 0.8 indicates that there is only enough operating income to cover 80% of the company’s debt payments.

Rather than just looking at an isolated number, it is better to consider a company’s debt service coverage ratio relative to the ratio of other companies in the same sector. If a company has a significantly higher DSCR than most of its competitors, that indicates superior debt management. A financial analyst may also want to look at a company’s ratio over time to see whether it is trending upward (improving) or downward (getting worse).

The Dividend Payout Ratio (DPR) is the amount of dividends paid to shareholders in relation to the total amount of net income the company generates. In other words, the dividend payout ratio measures the percentage of net income that is distributed to shareholders in the form of dividends.

Dividend payout Ratio = Dividends (or Dividends per Share) / Net income (income per Share)

Dividend Payout Ratio Formula

There are several formulas for calculating DPR:

1. DPR = Total dividends / Net income
2. DPR = 1 – Retention ratio (the retention ratio, which measures the percentage of net income that is kept by the company as retained earnings, is the opposite, or inverse, of the dividend payout ratio)
3. DPR = Dividends per share / Earnings per share

Interpretation of Dividend Payout Ratio

The dividend payout ratio helps investors determine which companies align best with their investment goals. When shareholders invest in a company, return on their investment comes from two sources: dividends and capital gains. The two sources of return are related as follows:

• A high DPR means that the company is reinvesting less money back into its business, while paying out relatively more of its earnings in the form of dividends. Such companies tend to attract income investors who prefer the assurance of a steady stream of income to a high potential for growth in share price.
• A low DPR means that the company is reinvesting more money back into expanding its business. By virtue of investing in business growth, the company will likely be able to generate higher levels of capital gains for investors in the future. Therefore, these types of companies tend to attract growth investors who are more interested in potential profits from a significant rise in share price, and less interested in dividend income.

The dividend payout ratio is not intended to assess whether a company is a “good” or “bad” investment. Rather, it is used to help investors identify what type of returns dividend income vs. capital gains – a company is more likely to offer the investor. Looking at a company’s historical DPR helps investors determine whether or not the company’s likely investment returns are a good match for the investor’s portfolio, risk tolerance, and investment goals. For example, looking at dividend payout ratios can help growth investors or value investors identify companies that may be a good fit for their overall investment strategy.

The DPR can also be used to gauge a company’s level of maturity, as follows:

• Younger, more rapidly growing companies are more likely to report a low DPR as they reinvest most of their earnings into the business for expansion and future growth.
• More mature, established companies, with a steadier but probably slower growth rate, are more likely to have a relatively high DPR as they do not feel the need to commit a high percentage of their earnings to business expansion. Blue chip stocks, such as Coca-Cola or General Motors, often have relatively higher dividend payout ratios.

Keep in mind that average DPRs may vary greatly from one industry to another. Many high-tech industries tend to distribute little to no returns in the form of dividends, while companies in the utility industry generally distribute a large portion of their earnings as dividends. Real estate investment trusts (REITs) are required by law to pay out a very high percentage of their earnings as dividends to investors.

Expense ratio (expense to sales ratio) is computed to show the relationship between an individual expense or group of expenses and sales. It is computed by dividing a particular expense or group of expenses by net sales.  Expense ratio is expressed in percentage.

Formula:

Expenses Ratio ( Particular expenses / Net Sales ) * 100

The numerator may be an individual expense or a group of expenses such as administrative expenses, sales expenses or cost of goods sold.

Significance and Interpretation:

Expense ratio shows what percentage of sales is an individual expense or a group of expenses. A lower ratio means more profitability and a higher ratio means less profitability.

Analyst must be careful while interpreting expense to sales ratio. Some expenses vary with the change in sales (i.e variable expenses). The ratio for such expenses normally does not change significantly as the sales volume increases or decreases. For fixed expenses (rent of building, fixed salaries etc.), the ratio changes significantly as the sales volume changes. The ratio is helpful in controlling and estimating future expenses.

In Mutual fund Industry

Annual Fund Operating Expenses, mostly known as the expense ratio, is the percentage of assets payable to the fund manager (i.e. AMC).

The asset manager, with the help of a team of analysts and other experts, allocate, manage (including the auditor and advisor fees) and advertise the fund to maximise returns and manage risks.

If the funds’ assets are small, then the expense ratio can be high. This is because the fund has to meet its expenses from a restricted or a smaller asset base.

Similarly, if the net assets of the fund are significant, then the expense percentage should ideally come down.
On 18 September 2018, SEBI brought about significant modifications by reducing TER of the mutual funds and changing the method of providing a commission to the distributors. Read more about it here

What are the Components of Expense Ratio?

The expense ratio includes numerous charges for smoothly running the mutual fund scheme. They recover this cost from the mutual fund investors on a day-to-day basis.
However, they disclose it to the investors once in every six months. Also, this will have a substantial impact on your take-home returns.
There are three major types of expenses as part of the expense ratio.

There are three major types of expenses as a part of the Expense Ratio. 

a. Management Fees

Mutual funds require the formulation of investment strategies before actually investing money in the underlying assets. Fund managers need to possess a high level of educational, relevant fund management experience, and professional credentials.

The management fee or investment advisory fee is compensation for these managers’ expertise. On average, this annual fee is about 0.50% to 1% of the funds’ assets.

b. Administrative Costs

The administrative costs are the expenses of running the fund. This would include keeping records, customer support, and service, information emails, and communications. They can vary greatly and are expressed as a percentage of fund assets.

c. 12-1b Distribution Fees

Many mutual funds collect the 12-1b distribution fee for advertising and promotional purposes. Usually, they charge their shareholders to market and promote the fund to the investors. These three fees combined are equal to the percentage of assets deducted from the fund.

Expense Ratio Limit By SEBI

All expenses of an AMC must be managed within limits specified under Regulation 52 of SEBI Mutual Fund Regulations. As per these regulations, the total expense ratio (TER) allowed is 2.5% for the first Rs.100 crore of average weekly total net assets, 2.25% for the next Rs.300 crore, 2% for the next Rs.300 crore and 1.75% for the rest of the AUM.
The limit for debt fund is 2.25%. On top of this, the Securities and Exchange Board of India allows all the mutual funds to charge 30 basis points more as an incentive to penetrate in smaller towns (B15 Cities). These cities also enjoy an additional 20 basis points as exit load charges.

How does Expense Ratio impact Fund Returns?

Expense ratios indicate how much the fund charges in terms of percentage annually to manage your investment portfolio. If you invest Rs.20,000 in a fund which has an expense ratio of 2%, then it means that you need to pay Rs.400 to the fund house to manage your money.

In simple words, if a fund earns returns equal to 15% and has TER of 2%, then you will make a return equal to 13%. The Net Asset Value (NAV) of a fund is reported after deducting all fees and expenses. Hence, it becomes essential to know how much are you paying to the fund house.

Expense Ratio Implications

Expense ratio indicates the percentage of sales to the total of individual expense or a group of costs. A lower rate means more profitability and a higher rate means lesser profitability. It becomes critical for schemes with comparatively more moderate yields.

Apart from that, you may use expense ratio to differentiate between actively managed and passively managed funds. In case of actively managed equity funds, the alpha generated by the fund manager is a compelling justification for the fee they charge. If you find a wide divergence between the returns of your fund and index funds, then you may think of making a switch.

Gross profit ratio (GP ratio) is a profitability ratio that shows the relationship between gross profit and total net sales revenue. It is a popular tool to evaluate the operational performance of the business. The ratio is computed by dividing the gross profit figure by net sales.

Gross profit margin is a profitability ratio that calculates the percentage of sales that exceed the cost of goods sold. In other words, it measures how efficiently a company uses its materials and labor to produce and sell products profitably. You can think of it as the amount of money from product sales left over after all of the direct costs associated with manufacturing the product has been paid. These direct costs are typically called cost of goods sold or COGS and usually consist of raw materials and direct labor.

The gross profit ratio is important because it shows management and investors how profitable the core business activities are without taking into consideration the indirect costs. In other words, it shows how efficiently a company can produce and sell its products. This gives investors a key insight into how healthy the company actually is. For instance, a company with a seemingly healthy net income on the bottom line could actually be dying. The gross profit percentage could be negative, and the net income could be coming from other one-time operations. The company could be losing money on every product they produce, but staying a float because of a one-time insurance payout.

Gross profit = Total Sales – Cost of Goods Sold

Gross profit Ratio = Gross Profit / Net Sales

Significance and interpretation:

Gross profit is very important for any business. It should be sufficient to cover all expenses and provide for profit.

There is no norm or standard to interpret gross profit ratio (GP ratio). Generally, a higher ratio is considered better.

The ratio can be used to test the business condition by comparing it with past years’ ratio and with the ratio of other companies in the industry. A consistent improvement  in gross profit ratio over the past years is the indication of continuous improvement. When the ratio is compared with that of others in the industry, the analyst must see whether they use the same accounting systems and practices.

Operating profit ratio establishes a relationship between operating Profit earned and net revenue generated from operations (net sales). operating profit ratio is a type of profitability ratio which is expressed as a percentage.

Net sales include both Cash and Credit Sales, on the other hand, Operating Profit is the net operating profit i.e. the Operating Profit before interest and taxes. Operating Profit ratio helps to find out Operating Profit earned in comparison to revenue earned from operations.

Formula to Calculate Operating Profit Ratio

Operating Profit Ratio = [Operating Profit / Revenue from Operations(Net Sales)] * 100

Note: It is represented as a percentage so it is multiplied by 100.

Operating Profit = Net profit before taxes + Non-operating expenses – Non-operating incomes

or

Operating Profit = Gross profit + Other Operating Income – Other operating expenses

Revenue From Operations (Net Sales) = (Cash sales + Credit sales) – Sales returns

High and Low Operating Profit Ratio

This ratio helps to analyze a firm’s operational efficiency, a trend analysis is usually done between two different accounting periods to assess improvement or deterioration of operational capability.

High: A high ratio may indicate better management of resources i.e. a higher operational efficiency leading to higher operating profits in the company.

Low: A low ratio may indicate operational flaws and improper management of resources, it is an indicator that the profit generated from operations are not enough as compared to the total revenue generated from sales.

The net profit percentage is the ratio of after-tax profits to net sales. It reveals the remaining profit after all costs of production, administration, and financing have been deducted from sales, and income taxes recognized. As such, it is one of the best measures of the overall results of a firm, especially when combined with an evaluation of how well it is using its working capital. The measure is commonly reported on a trend line, to judge performance over time. It is also used to compare the results of a business with its competitors.

Net profit is not an indicator of cash flows, since net profit incorporates a number of non-cash expenses, such as accrued expenses, amortization, and depreciation.

The formula for the net profit ratio is to divide net profit by net sales, and then multiply by 100. The formula is:

(Net profit after tax ÷ Net sales) x 100

The measure could be modified for use by a nonprofit entity, if the change in net assets were to be used in the formula instead of net profit.

Significance and Interpretation:

Net profit (NP) ratio is a useful tool to measure the overall profitability of the business. A high ratio indicates the efficient management of the affairs of business.

There is no norm to interpret this ratio. To see whether the business is constantly improving its profitability or not, the analyst should compare the ratio with the previous years’ ratio, the industry’s average and the budgeted net profit ratio.

The use of net profit ratio in conjunction with the assets turnover ratio helps in ascertaining how profitably the assets have been used during the period.

A high net profit margin means that a company is able to effectively control its costs and/or provide goods or services at a price significantly higher than its costs. Therefore, a high ratio can result from:

• Efficient management
• Low costs (expenses)
• Strong pricing strategies

A low net profit margin means that a company uses an ineffective cost structure and/or poor pricing strategy. Therefore, a low ratio can result from:

• Inefficient management
• High costs (expenses)
• Weak pricing strategies

Investors need to take numbers from the profit margin ratio as an overall indicator of company profitability performance and initiate deeper research into the cause of an increase or decrease in the profitability as needed.

Limitations of Net Profit Margin Ratio

When calculating the net profit margin ratio, analysts commonly compare the figure to different companies to determine which business performs the best.

While this is common practice, the net profit margin ratio can greatly differ between companies in different industries. For example, companies in the automotive industry may report a high profit margin ratio but lower revenue as compared to a company in the food industry.  A company in the food industry may show a lower profit margin ratio, but higher revenue.

It is recommended to compare only companies in the same sector with similar business models.

Other limitations include the possibility of misinterpreting the profit margin ratio and cash flow figures. A low net profit margin does not always indicate a poorly performing company. Also, a high net profit margin does not necessarily translate to high cash flows.

The operating ratio compares production and administrative expenses to net sales. The ratio reveals the cost per sales dollar of operating a business. A lower operating ratio is a good indicator of operational efficiency, especially when the ratio is low in comparison to the same ratio for competitors and benchmark firms.

The operating ratio is only useful for seeing if the core business is able to generate a profit. Since several potentially significant expenses are not included, it is not a good indicator of the overall performance of a business, and so can be misleading when used without any other performance metrics. For example, a company may be highly leveraged and must therefore make massive interest payments that are not considered part of the operating ratio. Nonetheless, this ratio is commonly used by investors to evaluate the results of a business.

To calculate the operating ratio, add together all production costs (i.e., the cost of goods sold) and administrative expenses (which includes general, administrative, and selling expenses) and divide by net sales (which is gross sales, less sales discounts, returns, and allowances). The measure excludes financing costs, non-operating expenses, and taxes. The calculation is:

(Production expenses + Administrative expenses) ÷ Net sales = Operating ratio

A variation on the formula is to exclude production expenses, so that only administrative expenses are matched against net sales. This version yields a much lower ratio, and is useful for determining the amount of fixed administrative costs that must be covered by sales. As such, it is a variation on the breakeven calculation. The calculation is:

Administrative expense ÷ Net sales

Significance and interpretation:

The operating ratio is used to measure the operational efficiency of the management. It shows whether or not the cost component in the sales figure is within the normal range. A low operating ratio means a high net profit ratio (i.e., more operating profit) and vice versa.

The ratio should be compared: (1) with the company’s past years ratio, (2) with the ratio of other companies in the same industry. An increase in the ratio should be investigated and brought to attention of management as soon as possible. The operating ratio varies from industry to industry.

Components of the Operating Ratio

Operating expenses encompass all costs except interest payments and taxes. Organizations do not factor in non-operating expenses, such as exchange rate costs, into the operating ratio, as these are extra expenses unrelated to core business activities.

Operating expenses include overheads such as general sales or administrative costs. Examples of overhead include expenses accrued because of owning a corporate office since, although it is necessary, it is not linked to the production process. Operating expenses include:

• Legal and accounting fees
• Banking charges
• Marketing or sales costs
• Office costs
• Wages or salaries

In some instances, operating costs include the cost of goods sold (COGS). Such expenses are directly related to the production process. That said, some companies prefer to keep operating costs and direct production costs separately. The direct product costs can include:

• Material costs
• Labor cost
• Wages and benefits for production workers
• Machine repair and maintenance costs

Total sales or revenue usually appears at the top of an income statement as the sum total that an organization generates.