## 10.1 – The Leverage Ratios

We touched upon the topic of financial leverage while discussing Return on Equity and the DuPont analysis. The use of leverage (debt) is like a double edged sword.

Well managed companies seek debt if they foresee a situation where, they can deploy the debt funds in an environment which generates a higher return in contrast to the interest payments the company has to makes to service its debt. Do recollect a judicious use of debt to finance assets also increases the return on equity.

However if a company takes on too much debt, then the interest paid to service the debt eats into the profit share of the shareholders. Hence there is a very thin line that separates the good and the bad debt. Leverage ratios mainly deal with the overall extent of the company’s debt, and help us understand the company’s financial leverage better.

We will be looking into the following leverage ratios:

- Interest Coverage Ratio
- Debt to Equity Ratio
- Debt to Asset Ratio
- Financial Leverage Ratio

So far we have been using Amara Raja Batteries Limited (ARBL) as an example, however to understand leverage ratios, we will look into a company that has a sizable debt on its balance sheet. I have chosen Jain Irrigation Systems Limited (JISL), I would encourage you calculate the ratios for a company of your choice.

**Interest Coverage Ratio:**

The interest coverage ratio is also referred to as debt service ratio or the debt service coverage ratio. The interest coverage ratio helps us understand how much the company is earning relative to the interest burden of the company. This ratio helps us interpret how easily a company can pay its interest payments. For example, if the company has an interest burden of Rs.100 versus an income of Rs.400, then we clearly know that the company has sufficient funds to service its debt. However a low interest coverage ratio could mean a higher debt burden and a greater possibility of bankruptcy or default.

The formula to calculate the interest coverage ratio:

**[Earnings before Interest and Tax / Interest Payment**]

The ‘Earnings before Interest and Tax’ (EBIT) is:

EBITDA – Depreciation & Amortization

Let us apply this ratio on Jain Irrigation Limited. Here is the snapshot of Jain Irrigation’s P&L statement for the FY 14, I have highlighted the Finance costs in red:

We know EBITDA = [Revenue – Expenses]

To calculate the expenses, we exclude the Finance cost (Rs.467.64Crs) and Depreciation & Amortization cost (Rs.204.54) from the total expenses of Rs.5730.34 Crs.

Therefore EBITDA = Rs.5828.13 – 5058.15 Crs

EBITDA = Rs. 769.98 Crs

We know EBIT = EBITDA – [Depreciation & Amortization]

= Rs.769.98 – 204.54

= Rs. 565.44

We know Finance Cost = Rs.467.64,

Hence Interest coverage is:

= 565.44/ 467.64

**= 1.209x**

The ‘x’ in the above number represents a multiple. Hence 1.209x should be read as 1.209 ‘times’.

Interest coverage ratio of 1.209x suggests that for every Rupee of interest payment due, Jain Irrigation Limited is generating an EBIT of 1.209 times.

**Debt to Equity Ratio:**

This is a fairly straightforward ratio. Both the variables required for this computation can be found in the Balance Sheet. It measures the amount of the total debt capital with respect to the total equity capital. A value of 1 on this ratio indicates an equal amount of debt and equity capital. Higher debt to equity (more than 1) indicates higher leverage and hence one needs to be careful. Lower than 1 indicates a relatively bigger equity base with respect to the debt.

The formula to calculate Debt to Equity ratio is:

**[Total Debt/Total Equity]**

Please note, the total debt here includes both the short term debt and the long term debt.

Here is JSIL’s Balance Sheet, I have highlighted total equity, long term, and short term debt:

Total debt = Long term borrowings + Short term borrowings

= 1497.663 + 2188.915

= Rs.3686.578Crs

Total Equity is Rs.2175.549 Crs

Thus, Debt to Equity ratio will be computed as follows:

= 3686.578 / 2175.549

**= 1.69**

**Debt to Asset Ratio:**

This ratio helps us understand the asset financing pattern of the company. It conveys to us how much of the total assets are financed through debt capital.

The formula to calculate the same is:

**Total Debt / Total Assets**

For JSIL, we know the total debt is Rs.3686.578Crs.

From the Balance Sheet, we know the total assets as Rs.8204.447 Crs:

Hence the Debt to Asset ratio is:

=3686.578 / 8204.44

**= 0.449 or ~45%.**

This means roughly about 45% of the assets held by JSIL is financed through debt capital or creditors (and therefore 55% is financed by the owners). Needless to say, higher the percentage the more concerned the investor would be as it indicates higher leverage and risk.

**Financial Leverage Ratio**

We briefly looked at the financial leverage ratio in the previous chapter, when we discussed about Return on Equity. The financial leverage ratio gives us an indication, to what extent the assets are supported by equity.

The formula to calculate the Financial Leverage Ratio is:

**Average Total Asset / Average Total Equity**

From JSIL’s FY14 balance sheet, I know the average total assets is Rs.8012.615.The average total equity is Rs.2171.755. Hence the financial leverage ratio or simply the leverage ratio is:

8012.615 / 2171.755

**= 3.68**

This means JSIL supports Rs.3.68 units of assets for every unit of equity. Do remember higher the number, higher is the company’s leverage and the more careful the investor needs to be.

## 10.2 – Operating Ratios

Operating Ratios also called ‘Activity ratios’ or the ‘Management ratios’ indicate the efficiency of the company’s operational activity. To some degree, the operating ratios reveal the management’s efficiency as well. These ratios are called the Asset Management Ratios, as these ratios indicate the efficiency with which the assets of the company are utilized.

Some of the popular Operating Ratios are:

- Fixed Assets Turnover Ratio
- Working Capital Turnover Ratio
- Total Assets Turnover Ratio
- Inventory Turnover Ratio
- Inventory Number of Days
- Receivable Turnover Ratio
- Days Sales Outstanding (DSO)

The above ratios combine data from both the P&L statement and Balance sheet. We will understand these ratios by calculating them for Amara Raja Batteries Limited.

To get a true sense of how good or bad the operating ratios of a company are, one must compare the ratios with the company’s peers /competitors or these ratios should be compared over the years for the same company.

**Fixed Assets Turnover**

The ratio measures the extent of the revenue generated in comparison to its investment in fixed assets. It tells us how effectively the company uses its plant and equipment. Fixed assets include the property, plant and equipment. Higher the ratio, it means the company is effectively and efficiently managing its fixed assets.

**Fixed Assets Turnover = Operating Revenues / Total Average Asset**

The assets considered while calculating the fixed assets turnover should be net of accumulated depreciation, which is nothing but the net block of the company. It should also include the capital work in progress. Also, we take the average assets for reasons discussed in the previous chapter.

From ARBL’s FY14 Balance Sheet:

= (767.864 + 461.847)/2

= Rs.614.855 Crs

We know the operating revenue for FY14 is Rs.3436.7 Crs, hence the Fixed Asset Turnover ratio is:

= 3436.7 / 614.85

=5.59

While evaluating this ratio, do keep in mind the stage the company is in. For a very well established company, the company may not be utilizing its cash to invest in fixed assets. However for a growing company, the company may invest in fixed assets and hence the fixed assets value may increase year on year. You can notice this in case of ARBL as well, for the FY13 the Fixed assets value is at Rs.461.8 Crs and for the FY14 the fixed asset value is at Rs.767.8 Crs.

This ratio is mostly used by capital intensive industries to analyze how effectively the fixed assets of the company are used.

**Working Capital Turnover**

Working capital refers to the capital required by the firm to run its day to day operations. To run the day to day operations, the company needs certain type of assets. Typically such assets are – inventories, receivables, cash etc. If you realize these are current assets. A well managed company finances the current assets by current liabilities. The difference between the current assets and current liabilities gives us the working capital of the company.

**Working Capital = Current Assets – Current Liabilities**

If the working capital is a positive number, it implies that the company has **working capital surplus** and can easily manage its day to day operations. However if the working capital is negative, it means the company has a **working capital deficit**. Usually if the company has a working capital deficit, they seek a working capital loan from their bankers.

The concept of ‘Working Capital Management’ in itself is a huge topic in Corporate Finance. It includes inventory management, cash management, debtor’s management etc. The company’s CFO (Chief Financial Officer) strives to manage the company’s working capital efficiently. Of course, we will not get into this topic as we will digress from our main topic.

The working capital turnover ratio is also referred to as Net sales to working capital. The working capital turnover indicates how much revenue the company generates for every unit of working capital. Suppose the ratio is 4, then it indicates that the company generates Rs.4 in revenue for every Rs.1 of working capital. Needless to say, higher the number, better it is. Also, do remember all ratios should be compared with its peers/competitors in the same industry and with the company’s past and planned ratio to get a deeper insight of its performance.

The formula to calculate the Working Capital Turnover:

**Working Capital Turnover =** **[Revenue / Average Working Capital]**

Let us implement the same for Amara Raja Batteries Limited. To begin with, we need to calculate the working capital for the FY13 and the FY14 and then find out the average. Here is the snapshot of ARBL’s Balance sheet, I have highlighted the current assets (red) and current liabilities (green) for both the years:

The average working capital for the two financial years can be calculated as follows:

Current Assets for the FY13 | Rs.1256.85 |

Current Liabilities for the FY13 | Rs.576.19 |

Working Capital for the FY13 | Rs.680.66 |

Current Asset for the FY14 | Rs.1298.61 |

Current Liability for the FY14 | Rs.633.70 |

Working Capital for the FY14 | Rs.664.91 |

Average Working Capital | Rs.672.78 |

We know the revenue from operations for ARBL is Rs.3437 Crs. Hence the working capital turnover ratio is:

= 3437 / 672.78

= **5.11 times**

The number indicates that for every Rs.1 of working capital, the company is generating Rs.5.11 in terms of revenue. Higher the working capital turnover ratio the better it is, as it indicates the company is generating better sales in comparison with the money it uses to fund the sales.

**Total Assets Turnover**

This is a very straight forward ratio. It indicates the company’s capability to generate revenues with the given amount of assets. Here the assets include both the fixed assets as well as current assets. A higher total asset turnover ratio compared to its historical data and competitor data means the company is using its assets well to generate more sales.

**Total Asset Turnover = Operating Revenue / Average Total Assets**

The average total assets for ARBL is as follws –

Total Assets for FY 13 – Rs.1770.5 Crs and Total Assets for FY 14 – 2139.4 Crs. Hence the average assets would be Rs. 1954.95 Crs.

Operating revenue (FY 14) is Rs. 3437 Crs. Hence Total Asset Turnover is:

= 3437 / 1954.95

**= 1.75 times**

**Inventory Turnover Ratio**

Inventory refers to the finished goods that a company maintains in its store or showroom with an expectation of selling the finished goods to prospective clients. Typically, the company besides keeping the goods in the store would also keep some additional units of finished goods in its warehouse.

If a company is selling popular products, then the goods in the inventory gets cleared rapidly, and the company has to replenish the inventory time and again. This is called the ‘Inventory turnover’.

For example think about a bakery selling hot bread. If the bakery is popular, the baker probably knows how many pounds of bread he is likely to sell on any given day. For example, he could sell 200 pounds of bread daily. This means he has to maintain an inventory of 200 pounds of bread every day. So, in this case the rate of replenishing the inventory and the inventory turnover is quite high.

This may not be true for every business. For instance, think of a car manufacturer. Obviously selling cars is not as easy as selling bread. If the manufacturer produces 50 cars, he may have to wait for sometime before he sells these cars. Assume, to sell 50 cars (his inventory capacity) he will need 3 months. This means, every 3 months he turns over his inventory. Hence in a year he turns over his inventory 4 times.

Finally, if the product is really popular the inventory turnover would be high. This is exactly what the ‘Inventory Turnover Ratio’ indicates.

The formula to calculate the ratio is:

**Inventory Turnover = [Cost of Goods Sold / Average Inventory]**

Cost of goods sold is the cost involved in making the finished good. We can find this in the P&L Statement of the company. Let us implement this for ARBL.

To evaluate the cost of goods sold, I need to look into the expense of the company, here is the extract of the same:

Cost of materials consumed is Rs.2101.19 Crs and purchases of stock-in-trade is Rs.211.36 Crs. These line items are directly related to the cost of goods sold. Along with this I would also like to inspect ‘Other Expenses’ to identify any costs that are related to the cost of goods sold. Here is the extract of Note 24, which details ‘Other Expenses’.

There are two expenses that are directly related to manufacturing i.e. Stores & spares consumed which is at Rs.44.94 Crs and the Power & Fuel cost which is at Rs.92.25Crs.

Hence the Cost of Goods Sold = Cost of materials consumed + Purchase of stock in trade + Stores & spares consumed + Power & Fuel

= 2101.19 + 211.36 + 44.94 + 92.25

COGS= Rs.2449.74 Crs

This takes care of the numerator. For the denominator, we just take the average inventory for the FY13 and FY14. From the balance sheet – Inventory for the FY13 is Rs.292.85 Crs and for the FY14 is Rs.335.00 Crs. The average works out to Rs.313.92 Crs

The Inventory turnover ratio is:

= 2449.74 / 313.92

**= 7.8 times**

**~ 8.0 times a year**

This means Amara Raja Batteries Limited turns over its inventory 8 times in a year or once in every 1.5 months. Needless to say, to get a true sense of how good or bad this number is, one should compare it with its competitor’s numbers.

**Inventory Number of days**

While the Inventory turnover ratio gives a sense of how many times the company ‘replenishes’ their inventory, the ‘Inventory number of Days’ gives a sense of how much time the company takes to convert its inventory into cash. Lesser the number of days, the better it is. A short inventory number of day’s number implies, the company’s products are fast moving. The formula to calculate the inventory number of days is:

**Inventory Number of Days = 365 / Inventory Turnover**

The inventory number of days is usually calculated on a yearly basis. Hence in the formula above, 365 indicates the number of days in a year.

Calculating this for ARBL:

= 365 / 7.8

= 46.79 days

**~ 47.0 days**

This means ARBL roughly takes about 47 days to convert its inventory into cash. Needless to say, the inventory number of days of a company should be compared with its competitors, to get a sense of how the company’s products are moving.

Now here is something for you to think about – What would you think about the following situation?

- A certain company under consideration has a high inventory turnover ratio
- Because of a high inventory turnover ratio, the inventory number of days is very low

On the face of it, the inventory management of this company looks good. A high inventory turnover ratio signifies that the company is replenishing its inventory quickly, which is excellent. Along with the high inventory turnover, a low inventory number of days indicate that the company is quickly able to convert its goods into cash. Again, this is a sign of great inventory management.

However, what if the company has a great product (hence they are able to sell quickly) but a low production capacity? Even in this case the inventory turnover will be high and inventory days will be low. But a low production capacity can be a bit worrisome as it raises many questions about the company’s production:

- Why is the company not able to increase their production?
- Are they not able to increase production because they are short of funds?
- If they are short of funds, why can’t they seek a bank loan?
- Have they approached a bank and are not been able to raise a loan successfully?
- If they are not able to raise a loan, why?
- What if the management does not have a great track record, hence the banks hesitation to give a loan?
- If funds are not a problem, why can’t the company increase production?
- Is sourcing raw materials difficult? Is the raw material required regulated by government (like Coal, power, Oil etc).
- Difficult access to raw material – does that mean the business is not scalable?

As you can see, if any of the points above is true, then a red flag is raised, hence investing in the company may not be advisable. To fully understand the production issues (if any), the fundamental analyst should read through the annual report (especially the management discussion & analysis report) from the beginning to the end.

This means whenever you see impressive inventory numbers, always ensure to double check the production details as well.

**Accounts Receivable Turnover Ratio**

Having understood the inventory turnover ratio, understanding the receivable turnover ratio should be quite easy. The receivable turnover ratio indicates how many times in a given period the company receives money/cash from its debtors and customers. Naturally a high number indicates that the company collects cash more frequently.

The formula to calculate the same is:

**Accounts Receivable Turnover Ratio = Revenue / Average Receivables**

From the balance sheet we know,

Trade Receivable for the FY13 : Rs.380.67 Crs

Trade Receivable for the FY14 : Rs. 452.78 Crs

Average Receivable for the FY13 : Rs.416.72

Operating Revenue for the FY14 : Rs.3437 Crs

Hence the Receivable Turnover Ratio is:

= 3437 / 416.72

= 8.24 times a year

~ 8.0 times

This means ARBL receives cash from its customers roughly about 8.24 times a year or once every month and a half.

**Days Sales Outstanding (DSO) )/ Average Collection Period/ Day Sales in Receivables**

The days sales outstanding ratio illustrates the average cash collection period i.e the time lag between billing and collection. This calculation shows the efficiency of the company’s collection department. Quicker/faster the cash is collected from the creditors, faster the cash can be used for other activities. The formula to calculate the same is:

**Days Sales outstanding = 365 /** **Receivable Turnover Ratio **

Solving this for ARBL,

= 365 / 8.24

= 44.29 days

This means ARBL takes about 45 days from the time it raises an invoice to the time it can collect its money against the invoice.

Both Receivables Turnover and the DSO indicate the credit policy of the firm. A efficiently run company, should strike the right balance between the credit policy and the credit it extends to its customers.

### Key takeaways from this chapter

- Leverage ratios include Interest Coverage, Debt to Equity, Debt to Assets and the Financial Leverage ratios
- The Leverage ratios mainly study the company’s debt with respect to the company’s ability to service the long term debt
- Interest coverage ratio inspects the company’s earnings ability (at the EBIT level) as a multiple of its finance costs
- Debt to equity ratio measures the amount of equity capital with respect to the debt capital. Debt to equity of 1 implies equal amount of debt and equity
- Debt to Asset ratio helps us understand the asset financing structure of the company (especially with respect to the debt)
- The Financial Leverage ratio helps us understand the extent to which the assets are financed by the owner’s equity
- The Operating Ratios also referred to as the Activity ratios include – Fixed Assets Turnover, Working Capital turnover, Total Assets turnover, Inventory turnover, Inventory number of days, Receivable turnover and Day Sales Outstanding ratios
- The Fixed asset turnover ratio measures the extent of the revenue generated in comparison to its investment in fixed assets
- Working capital turnover ratio indicates how much revenue the company generates for every unit of working capital
- Total assets turnover indicates the company’s ability to generate revenues with the given amount of assets
- Inventory turnover ratio indicates how many times the company replenishes its inventory during the year
- Inventory number of days represents the number of days the company takes to convert its inventory to cash
- A high inventory turnover and therefore a low inventory number of days is a great combination
- However make sure this does not come at the cost of low production capacity

- The Receivable turnover ratio indicates how many times in a given period the company receives money from its debtors and customers
- The Days sales outstanding (DSO) ratio indicates the Average cash collection period i.e the time lag between the Billing and Collection

I was confused on why employee benefits were not counted in COGS. So, I googled COGS and found out this on investopedia

“There are several ways to calculate COGS but one of the more basic ways is to start with the beginning inventory for the period and add the total amount of purchases made during the period, and then deducting the ending inventory. This calculation gives the total amount of inventory or, more specifically, the cost of this inventory, sold by the company during the period. Therefore, if a company starts with $10 million in inventory, makes $2 million in purchases and ends the period with $9 million in inventory, the company’s cost of goods for the period would be $3 million ($10 million + $2 million – $9 million).”

So for Amaraja Batteries FY13-14, this would look like COGS = (3404+292 -335) = 3359 Crores.

This reduces the GPM significantly. GPM = (3404-3359)/3404 = 1.3%

I am sure I am reading something terribly wrong. Not sure what.

This is the link where I found the alternate way to calculate COGS.

I think I found my mistake. Investopedia is suggesting this formula: COGS = Last Year Inventory + Total Expenses – Current Inventory. For ARBL, FY 13-14 this formula is giving COGS = 292 + 2942 – 335 = 2899 Crores. This implies GPM = 3403-E3)/3403 = 14%. Please note that moneycontrol.com also shows a GPM of 14% for ARBL for FY13-14 (http://moneycontrol.com/financials/amararajabatteries/ratios/ARB). Your calculation shows a GPM of 28% for ARBL for the same year. I am not sure who is right and who is wrong.

Ajit – The GMP calculation is shown here – (/varsity/chapter/equity-research-part-1/). Calculation of COGS varies a bit from company to company. Also please dont rely on moneycontrol, I’ve found errors multiple times. Suggest you try morningstar India website.

For a general calculation can’t we use the formula COGS = Current Total Expense + last year inventory – current inventory? I was hoping that this formula works. This would have saved me in looking into each item of expenses and figure out which will go into COGS.

Thanks for your advice regarding moneycontrol. I will check out morningstar now. — Best regards

Ajit – Maybe I need to explore this a bit deeper.. honestly I’ve never used the formula Investopedia suggests i.e COGS = Current Total Expense + last year inventory – current inventory. In fact more often than not I end up using the one that I have mentioned in the chapter.

Also on another note, the value that you calculate and the ones mentioned on sites like moneycontrol, morningstar, ET markets etc will hardly ever match point to point…it will differ by few bps. Hence for this reason I always tend to treat these ratios as a ballpark.

The difference were not small. You were speaking of the same ratio GPM in the range of 28% where the investopedia’s formula was giving GPM in the range of 14%, unless I am misinterpreting the formula.

I understand, like I said I have not used that formula for COGS. Need to dwell more on it. Will surely get back on it as it is learning for me as well.

There is a typo in the calculation of Fixed Asset Turnover Ratio of ABRL. Since the operating revenue is 3437 and not 353.7, this ratio should be 5.5 and not 0.55.

Thanks, making the correction now.

Another typo I guess. Average asset of ABRL for FY2013-14 is 1954 and not 614. Therefore, the total asset turnover should be 1.7 and not 5.5. I hope I am not annoying you.

Ajit, I rechecked the numbers. Rs.614 Crs seems to be the Average total assets for FY13 and FY14. Unless I’m missing something very obvious !

Total asset: FY14 = 2139.4, FY13 = 1770.5 Crores. Average = (2139.4 + 1770.5)/2 = 1954.95

Ah got it 🙂

You are taking the sum total of both Current and Non current assets. However in ‘Fixed Asset’ Turnover ratio, the assets being refereed to is just ‘Fixed Asset” and not all the assets.

No you did not 🙂 The typo I am referring to is in the calculation of Total Asset Turnover ratio. You seem to have calculated Fixed Asset Turnover ratio again.

My bad ! and I’m quite embarrassed :). Thank you so much for pointing this out, I’ve made the necessary changes.

Thank you. I think I did not emphasize enough in the description about the whereabouts of the error. Anyway …. could you please have these typo related comments deleted now? There purpose is over now.

I guess the comments should be there, to constantly remind us to be more diligent while proof reading 🙂

Mr. Karthik

In Interest Coverage Ratio why we have subtracted Depreciation & Amortization cost (Rs.204.54) two times from total expenses. Please clarify

Hi Ashish,

Thank you for pointing out the error, we have made the necessary corrections.

Sir,

What is the basic difference between Fixed Asset Turnover and Total Asset Turnover?

Thank you With Best Regards.

The basic difference is :-

The Total asset turnover ratio helps a firm to evaluate how well it is utilizing all its assets while it is trying to generate its revenue vis-a-vis a Fixed asset turnover ratio which evaluates how well a firm is utilizing its fixed assets while it is trying to generate its revenue.

So, a high total asset turnover and fixed asset turnover ratio indicates efficient utilization of a firm’s assets and a low total asset turnover and fixed asset turnover indicates inefficient utilization of a firm’s assets.

Interest Coverage Ratio: the formula is correct but you have put in value of EBITDA(769.98 Cr) instead of EBIT(565.44 Cr) beacuse of which the ratio comes out to be 1.67 which should be 1.209…i guess!!

Oops, thanks for pointing this, will make the necessary corrections.

Thank you for pointing out the error. We have made the necessary corrections.

why is change in inventories of finished goods, WIP not included in cogs???

Mostly because they are balance sheet items.

Which is valid?

(From The Financial Ratio Analysis (Part 1))

In ROE DuPont Model

Financial Leverage = Average Total Assets / Average Shareholders Equity

(From The Financial Ratio Analysis (Part 2))

Financial Leverage Ratio=Average Total Asset / Average Total Equity

Both are same i.e Avg Shareholder Equity = Average Total Equity.

In Financial Leverage Ratio,Average Total Asset is 8912.615 but correct value is 8012.6155.

If yes,please correct it.

Thank you for pointing out the error. We have made the necessary corrections.

I would like to ask u What does negative (or) zero working capital & receivable days mean??

Working Capital (WC) = Current Assets – Current Liabilities

Hence -ve WC indicates that the current liabilities are more than current assets.

and what is the difference between operating leverage and financial leverage??

The operating leverage measures the effect of fixed costs on the total cost structure of the company

So, firms which incur higher proportion of fixed costs in comparison to their variable costs are considered to have a high operating leverage, whereas firms which incur lower fixed costs and higher variable costs are considered to have a lower operating leverage

Financial leverage measures the amount of debt financing on the total capital structure of the company

So, firms which use higher debt in proportion to equity are considered to have higher financial leverage, whereas firms which use lower debt in proportion to equity are considered to have lower financial leverage.

Is EBIT and PBIT different??If different then could u please explain why are they different i am really confused over both the terms

They are the same Micheal.

Is there any difference between “Share Capital” and “Total Number of Shares”? Or are they both same?

They both are related. For example if the Share Capital of a company is Rs.10Crs, with the face value of each share as Rs.5, then the number of shares will be –

Share Capital / Face Value

= 10 Cr / 5

= 20 Lakh shares.

Hi, sir

EBIT=EBITDA-Depretiation and Amortizatio

or

EBIT=EBITDA+Depretiation and Amortization?

which one is correct?

EBIT=EBITDA – Depreciation and Amortization.

HI,

EBIT=Earning Before Interest and Tax…..

EBITDA= Earning Before Interest Tax and Depreciation and Amortization….

here which one is includes or excludes Depreciation and Amortization cost?

EBITDA includes D&A.

EBITDA – D&A = EBIT.

If I calculate interest coverage ratio for amaraja battery-

EBITDA=560cr

EBIT=560-64=496cr

financial cost=.7cr

so interst coverage ratio=496/.7=708 x

is my calculation correct, how come interest coverage ratio is coming so high i.e 708?

Hi Rohan,

Thank you for your query. You are right about the calculation of the interest coverage ratio. It is 708 times because the denominator ( interest component) is a negligible amount. Please note it is a good number for an investor because it shows, the company has sufficient funds to service the debt. However a high ratio like this could also indicate, that the company is not using leverage to the fullest to increase its earnings.

where to find inventory values 292.85 cr and 335 cr in annual report?

I am not able to find them

Please see the circled images in the attachment, I have extracted the same from ARBL Annual Report ( 2013- 2014) – from its Balance Sheet.

while calculating fixed asset turnover operating revenue is taken as 343.7 crs. Whereas in annual report net revenue is mentioned as 34367m, which if converted to crores comes out to be 3436.7 cr and not 343.7crs. so from where 343.7crs value is taken in annual report?

Hi Rohan,

Thank you for your query. You are right about the calculation of revenue. The operating revenue for the calculation is arrived at as follows :

= 34367 * 10,00,000 / 100,00,000 = Rs. 3436.7 crores.

We have made the necessary corrections.

same formula has been mentioned for 2 ratios fixed assets turnover and total assets turnover i.e operating revenue/average total assets.

same formula means same value, then why 2 different ratios?

is it by mistake or they imply same thing?

Fixed asset takes into consideration long term assets, but total asset turnover takes into consideration both fixed and current assets. So there is a slight difference between the two.

First of all it is an amazing website. Dear Mr. Karthik as per my understanding we cannot ascertain COGS from financial statements since it does not provide enough information on items like Direct Labour (which may be very crucial in industries that are labour intensive.

After looking at a textbook on accounting the formula for COGS looks like Raw material consumed + Direct Labour + Depreciation related to plant and machinery and building used in production process + Other Manufacturing Expenses + Opening stock WIP – Closing Stock WIP gives us Cost of Production. From the Cost of Production we add opening stock of finished goods and subtract closing stock of finished goods to get COGS. So we can only get Cost of Sales and not COGS.

Further, in many annual accounts “Other expenses” do not present data which provide segregated costs that are function-wise like the one given in ARBL so we need to use some amount of judgement to decipher the ones that are related to manufacturing.

Kindly correct me if I am wrong it would be of great help. How can one learn financial modeling from your website and pro forma financial statement forecasting

Sanat – absolutely. In fact for each company based on the nature of business we need to arrive at the variables which would make up for the cost of goods sold. Clearly one size does not fit all!

Dear sir, pls explain that in INTREST COVERAGE RATIO, you have mention EBITDA – EBIT – DA, Now my question is we have already deducted DA in EBITDA then why again we have to deduct DA in EBIT calucualtion.

No, we need not deduct D&A from EBIT. Interest Coverage ratio (ICR) is EBIT/Interest paid.

Couple of things you need to note –

1) While taking the Interest amount in the denominator, make sure you take the interest amount from the schedule, as some companies tend to capitalize the interest to show less interest amount and boost the bottom line

2) If the interest coverage is higher than 3 then it is a good sign, you need to be careful if ICR is between 1.5 and 3, and finally if the ICR is less than 1.5 then please do watch out for such companies as there is a high chance of them defaulting on interest payments.

Dear sir, can you please explain how to calculate interest coverage ratio when company is capitalizing interest cost, for ex. i have taken of godrej properties( consolidated 15-16), in that company is showing finance cost as 15.35 cr. but its real fincance cost is on page 195 given BANKS 140 CR., OTHERS 190 CR., OTHER BORROWING COST 81 CR. Now how to calculate this, please explain so that in case of company capitalizing interest we can calculate.

You need to add up these costs and consider this as the interest costs. Take EBIT and divide it over interest costs to get the ICR.

HELLO scheiss-leben I THANK YOU ENORMOUSLY FOR THIS GREAT SERVICE OF EDUCATING PEOPLE LIKE ME FINANCIALLY, CAN YOU SHED A LITTLE LIGHT ON VERIFYING PRODUCTION PARAMETERS WHEN THERE ARE GOOD “INVENTORY DAYS” NUMBER,IS LACK OF GROWTH IN REVENUE NUMBERS ONE OF THEM

Thanks Srikanth.

Inventory days is a simple calculation. You just divide ‘Inventor Turnover’ by 365. Inventory Turnover is sales/Inventory. Higher the number, the higher is the number of days for the company to convert inventory into cash. Always make sure you compare the company’s numbers with its peers to know how it stacks up.

Hi dear Karthik

Trade Receivable for the FY13 : Rs.380.67 Crs

Trade Receivable for the FY14 : Rs. 452.78 Crs

Average Receivable for the FY13 : Rs.416.72

why is it 416.72

should be 607.0

thanks for replying in advace

Average Trade Receivable for FY13 would be Average of Trade Receivable for FY12 and Trade Receivable for FY13.

416.72 got it thanks but it is for FY14 isn’t it?

by the way do you have those materials in the Hindi?

Lot of thanks

Yup.

Will try and get this in Hindi.

Thanks, Please paste the Hindi link when you are able as well

it would be better to understand for the beginners

Sure, will do. Thanks.

Dear Karthik, awesome job!!! Great job…. Wanted to know one thing. Isn’t COGS already calculated in WIP Inventory cost? For example, across the sources, I say that WIP Inventory = Raw inventory + Direct Labour + Manufacturing Overheads…. However, I understand that the way it is done here is different. In that case, how is WIP Inventory cost getting calculated here?

Looking forward to your reply!!! Thanks……

Thanks, happy to know you liked our content!

COGS is expense which is ‘already’ incurred against which revenues are recognised. However, WIP is an on going expense and the revenues will be recognised at a later point.

Thans Kathik….Its a great thing you’re doing…and as an engineer, venturing into this filed, I shall remain indebted to you….. Now, u see, (Sorry that I’m a lil confused) COGS is change in finished goods (Opening+Produced-Finishing) and finished goods cost include manufacturing cost….So, how can change in WIP be negative…. As in it must then be that somewhere else in P&L statement total cost for WIP is getting added, then we must be subtracting unused WIP somewhere…. Where is this total cost being added?

I mean, should not direct labor and other manufacturing cost be reflected under the Expense Head? And, if I may ask, could you in a couple of words say how fixed costs are added to the WIP Inventory (for example utilities cost/rent cost, etc)

Getting an exact split up of fixed costs under WIP is quite tough, you will get some explanation under the associated notes. I’d encourage you to pull out the AR of some other company and study this to get a deeper insight.

hmmm…interesting, please do give me sometime to put my thoughts together. Will get back shortly.

Thanks a lot Karthik…… I shall wait for your reply!! In the meantime, I’m indeed trying to go through a couple of other AR and get a better understanding….

P.S.: You’re doing a fantabulous job…Kudos!!!

Cheers!!

Karthik, looking forward to your reply…hope you got some time!!

Hello,

EBITDA calculated through [Total Revenue – Other Income] – [Total Expense – Finance Cost – Depreciation & Amortization] in last page yields a different result – 560 crs whereas EBIDTA calculated in interest coverage ratio yields EBITDA = [Revenue – Expenses] yields 769.98 crs. Which one is correct?

Thanks!

Guru, if I may, as I’m not a pro… EBITDA, should not have ” Depreciation & Amortization” subtracted from it. In your first formula ” Depreciation & Amortization” is getting subtracted from earning… hence, your second answer is correct….

Looking forward to someone more experienced in confirming my answer

EBITDA = [Total Revenue – Other Income – Operating Expense]

Apologies if I’ve used any other number, I guess its a mistake and I will look into it.

Hello Karthik sir

Higher the interest coverage ratio good or not and how much the interest coverage ratio should be for a better company?

Thanks

Generally an ICR of over 3 is desirable. Between 1.5 to 3 is alright…and below 1.5 is something I’d not be comfortable with.

Thank-you

Welcome!

Hi Karthik,

Working capital for Maruri Suzuki is coming negative for FY’16 and FY’15, hence the capital turnover ratio is coming to -14.451, i have taken figures from https://marutistoragenew.blob.core.windows.net/msilintiwebpdf/Consolidated_BalanceSheet.pdf, is it possible ?

Regards,

MSP

Yes, -ve working capital is possible and in some case desirable. Common reason is when the company receives money as advance from its clients (or vendors) towards the company’s products, then this reflects in the current liabilities, and therefore it leads to a -ve working capital.

Hello,

In your debt to asset ratio example on Jain Irrigation Systems you have told total debt is Rs.3686.578Crs which is right. But you have told total assets as Rs.8204.447 Crs, which I am not seeing in March 2014 balance sheet. Is that your typo? I am seeing a total asset of 5,882.60Crs in march 2014.

I am trying to get all these ratios from Money control itself. Can you tell me if I can directly see debt to asset ratio in money control ?

I’m not too sure if MC is the right source. Please refer to the annual report directly.

Hello,

With respect to Working Capital Turnover ratio can I look at Number of Days In Working Capital in money control and use this? Will this give almost the same type of information right?

I’d suggest you use screener.in or ratestar.in instead of MC.

Hi Karthik,

First of all I would like thank you for these wonderful modules. I am using Jamna Auto Industries AR 2016 to calculate all of the ratios. So far the results were very good. However, the working capital of Jamna Auto Industries is -negative 51 cr. So I am unable to calculate the Working Capital Turnover Ratio.

What does this -negative working capital exactly convey and how much difference can it make as compare to other ratios. The results of Jamna Auto for all the ratios till now were excellent except for the working capital.

Thank you.

WC is defined as CA-CL. It turns negative when CL is a larger number than CA. Now, CL also includes payable. Now imagine, if your products are so good, than your customers have paid you in advance to get the finished goods. In this case customer advances will be treated as payables. This will lead to a -ve working capital. So you need to clearly look into why WC is -ve.

Thanks for the reply :)..Yes WC is negative due to High Trade Paybles.

In that case you should consider it as a positive.

Why do we divide interest(finance cost) from the EBIT?

&

Why to subtract Dep&Amortization double time in interest coverage ratio?

Have you read through this chapter?

”Interest coverage ratio of 1.209x suggests that for every Rupee of interest payment due, Jain Irrigation Limited is generating an EBIT of 1.209 times”

Does it mean for each rs(1 rs) of interset payment due company is generating 1.209% of Rs 1?

It means for 1/- interest, they are generating Rs.2 in revenue.

I think you typed the mistake in Account receivables turnover ratio . You typed this

Trade Receivable for the FY13 : Rs.380.67 Crs

Trade Receivable for the FY14 : Rs. 452.78 Crs

Average Receivable for the FY13 : Rs.416.72

For calculating acc. receviables ratio FY14=(Oper Revenue FY 14)/(Avg receivables FY14) right .But you typed Avg. Receivables for FY13

Thanks for pointing this out, let me check through this.

Hi Karthik,

You said EBIT is EBITDA – Depreciation & Amortization,

Shouldn’t it be EBITDA + Depreciation & Amortization?

O wait. You are right!!

Cheers!

No, D&A falls under expenses, hence you deduct it.

Financial Leverage Ratio – “Do remember higher the number, higher is the company’s leverage and the more careful the investor needs to be.” That’s what your comment is. But, higher this number, the safer the company is. If more assets are fund by equity, less debt is required. Also, it shows shareholders trust the company and so put more money into it.

Equity is not leverage, Anand. Debt is. I was referring to the debt bit here.

Sorry, my bad. I got confused there.

BTW nice presentation. Easy to understand.

Happy learning!

Hello,

Can you please demonstrate how to find out credit sales and credit purchase from the annual report of a company to calculate debtors and creditors turnover ratios,

Thank-you

This is usually reflected in the trade payable and trade receivable part in the balance sheet.

COGS(cost involved in producing goods) is =2449.74

Average Inventory is= 313.92

-If avg inventory is 313.92 where does the inventory of worth 2135.82 (2449.74-313.92) is gone,

-why inventory is shown of 313.92 instead of 2449.74, while inventory should be equal to Cost involved in producing inventories.

COGS is raw material cost….you consume this to produce products. Inventory represents part of finished goods which are not yet converted to cash (revenue). Whatever has been converted to cash is shown as revenues.

Sir, I have one question.. Please make it clear..

When we going to calculate EBITDA why don’t you include the ‘other income’ of the company ? Please explain..

Thank you..

Ideally, EBITDA should report operational efficiency, for which we need operational income. Other income is not from operations. Hence we ignore it.