9.16 Application of ratios

Ratio Analysis

All these ratios are used for financial analysis, but with a different purpose. The stock market-related ratios are applied to anticipate the future market price of a company and in making buying and selling decisions of shares. All other groups of ratios do not have a direct bearing on the price but are quite important in analyzing the financial and operational health of a company. Unless these five groups of ratios suit the criteria, no matter how attractive the stock market related ratios look; do not consider the share of the company for the investment. A precise understanding of factors influencing stock Price would make you comprehend these ratios better.

What does book value signify?

The book value per share is the total shareholders’ funds per share. Thus, if a company were dissolved, each equity share would receive a sum equal to its book value. Ideally, the minimum market price of a share should be equal to its book value. Remember that book value per share is also known as net asset value (NAV) because it gives the value of the net assets of a company.

How is the book value used for investment decisions?

For instance:

1. When the book value of a company is low (but higher than its face value), you may conclude that the reserves and surplus position of the company is not good. If such a company announces some expansion and diversification plan, you may expect a right issue.
2. When the book value of a company is too high, it means its free reserves are very large. In such cases, a company may consider conversion of a part of these reserves into equity by giving bonus shares. As a rule, companies having a book value of above Rs 50 (for a Rs 10 face value share) are potential bonus candidates. In the case of such companies, look for its book value before purchase.
3. A company having a low equity base has a high book value and hence is more likely to declare bonus. You may therefore bank upon such companies for investment.
4. Companies with a negative book value or a book value lower than the face value of its shares have past losses carried forward in their balance sheets. Be wary of such companies, especially the ones with a negative book value. Avoid them unless you have information about their future performance. These companies generally attract the speculators’ fancy as they could betaken over by the larger profitable companies. This is all about the stock market related ratios.

How important is the interest coverage ratio?

The interest coverage ratio is a measure of a company’s ability to repay loans. Interest coverage ratio of about 1.5-2 times is ideal. High interest coverage is good, but too high a ratio shows conservatism of a company towards debt. If the ratio is too low, resist from investing in the shares of such a company.

How does one use the activity ratios?

If you read the definitions, you would understand that all these ratios basically show how a company manages its different operations for generating sales. The lower the activity ratios, the better would be the profitability of the company. Again compare these ratios over a period of time as well as with the competitors to check improvement or failure in management. Both inventory-turnover ratio and debtor-turnover ratio fall when there is a strong demand for the products. When an industry undergoes recession, the inventory turnover, debtor turnover and working capital turnover ratios show a climb. Now that various aspects of investment analysis are clear, could we summarise how to go about conducting an analysis?

The emphasis is on three steps:

1. Do an industry analysis to identify the industry heading for a boom.
2. Undertake financial analysis to identify a company for investment.
3. Confirm your findings from the financial analysis or corporate analysis.

You can identify a company from a list of companies with low P/E ratios. Alternatively, you may identify it based on tips received from an investment magazine or some insider. Then work out the industry and corporate analysis to confirm whether the investment is worthwhile.