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# Financial Ratios and Metrics

Financial ratios are numbers which can help investors interpret the financial
performance, health, and efficiency of a company.

Although financial ratios can seem like an attractive tool to make quick
judgments about a company, **in isolation**, a financial ratio conveys little
information and, in some cases, can be misleading as well.

One of the most popular financial ratios, the price to earnings (PE) ratio, is
used by a lot of investors to somehow judge the "value" of a company which may
or may not always make sense. Avenue Supermarts, a chain of supermarkets across
India, made its debut on the NSE on 21st March 2017 at a PE ratio of
approximately 105 and since then it has rarely exhibited a PE ratio of less
than 90.

Of course, this doesn't mean that the PE ratio isn't useful but one should know
how and, more importantly, when to use it. This goes for all financial ratios
we're going to talk about.

In the following sections, we'll take a look at various financial ratios, their
implications, and their relevance across different sectors.

## Profitability Ratios

### Gross Profit

There are three major types of profit -

- gross profit
- operating profit
- net profit

Each of them are significant in their own way.

The **Gross Profit** is the amount of money a company earns after deducting the
costs *directly* associated with producing their goods/products/services from
the revenue. These costs are collectively known as **Cost of Goods Sold** or
**COGS**.

How do we define COGS though and what do *directly associated* costs mean?
Interestingly, the answer can vary depending upon the company we're looking at.
Let's look at some examples.

Here's an image from the 2020 annual report of Motherson Sumi, an auto
ancillary company.


For a capital intensive company like Motherson Sumi which deals with a lot of
tangible raw materials, it should be expected that the *cost of materials
consumed* would be relatively high. *Purchase of stock-in-trade* measures the
expenses incurred in buying products used as intermediates to create the
finished product sold by the company. *Change in inventories of finished goods,
work-in-progress, and stock-in-trade*, as the name implies, are the expenses
incurred on creating the products left in the inventory of Motherson Sumi at
the end of the financial year 2020.

These costs can be considered directly associated with creating the end
product. Expenses like the *finance costs* or *depreciation & amortization*
aren't directly related to the creation of the end product. We can ask the
following question to think whether an expense qualifies as COGS — **would this
expense have emerged even if no sales were generated?** If yes, then it
probably shouldn't be included in COGS.

The labor costs incurred to produce the end product are also direct costs
eligible for inclusion in COGS. However, this should only include actual labor
costs paid to employees responisble for creating the product, not employees in
marketing or HR, for example. This is a conundrum because the notes for
*employee benefit expenses* looks like this —


We don't know the details of how much of the *salary, wages, & bonus* are
direct costs. The details are not mentioned possibly due to competitive and
logistical reasons.

We leave the decision of inclusion of *employee benefit expenses* in COGS upto
the reader and his/her judgement which will possibly be influenced by the
company in question and its nature of business. Please note that these expenses
would still be reported under the operating expenses and end up getting
reflected in the operating profit.

In this case, we'll consider COGS as

COGS = Cost of Materials Consumed + Purchase of Stock-in-Trade + Changes in Inventories of Finished Goods, Work-in-Progress, and Stock-in-Trade

This gives us `₹35,547 + ₹710 + ₹14.5 = ₹36,271.5 crores`.

Let's look at the P&L statement in TCS' 2020 annual report.


Since TCS is a services company, it doesn't deal with or manufacture any raw
materials or tangible goods. TCS' tangible material is its software licenses
and employees who provide services worldwide. In this case, the COGS would be
`₹85,952 + ₹1,905 = ₹87,857 crores`.

Now that we know how to calculate COGS, we can calculate the gross profit.

Gross Profit = Revenue from Operations - COGS

Motherson Sumi's gross profit for the financial year 2020 was `₹63,536.8 -
₹36,271.5 = ₹27,265.3 crores`.

### Earnings Before Interest, Taxes, (Depreciation and Amortization) (EBIT/EBITDA)

**EBIT**, as the name implies, is the amount of profit a company earns
**before** interest and tax expenses have been subtracted. It is also known as
the **Operating Profit**. We can also strip out depreciation costs of tangible
assets and amortization costs of intangible assets from the expenses to obtain
the **EBITDA**.

Here's the P&L statement of Abbott India for the financial year 2020.


The revenue from operations for the year ended March 2020 was `₹4,093.14
crores`. We won't consider other income here because it isn't generated from
operations. The total expenses excluding taxes are `₹3,404.83 crores`. If we
exclude finance costs (interest) of `₹8.53 crores` from the total expenses, it
gives us operational expenses of `₹3,396.3 crores`. Thus, the EBIT in this case
turns out to be `₹4,093.14 - ₹3,396.3 = ₹696.84 crores`.

You can use the following formula to calculate EBIT.

EBIT = Revenue from Operations - ( Total Expenses Excluding Taxes - Finance Costs )

To calculate the EBITDA, we can simply exclude the depreciation and
amortization expenses. The formula then becomes

EBITDA = EBIT + Depreciation and Amortization Expense

In this case, the EBITDA is `₹696.84 + ₹59.60 = ₹756.44 crores`.

Why is the EBIT and EBITDA of a company relevant?

EBIT and EBITDA present us with an ideal view of the companies' core
operational performance by excluding non-operational expenses like interests
and taxes. While the net profit might be skewed by variables like taxes, EBIT
and EBITDA will present the true picture of how much the company actually
earned from its operations.

EBIT and EBITDA are influenced by the ability of the company to earn revenue
and the operational expenses it incurs. The EBIT margin (EBIT in terms of % of
revenue) of Abbott India for the financial year 2020 was 17.02% while that of
Pfizer India for the same period was 21.81%. Using these numbers, we can infer
that Pfizer India was operationally more profitable than Abbott India during
the financial year 2020. Again, keep in mind that this is just one of many data
points.

Like most financial ratios and metrics, EBIT and EBITDA are best used for
comparison of companies in the same sector. Comparing the EBIT margin of a MNC
pharmaceutical company with that of a capital intensive auto ancillary company
doesn't make sense.

### Profit Before Tax (PBT) and Profit After Tax (PAT)

As the name implies, **Profit Before Tax (PBT)** is the amount of profit a
company earns before subtracting the taxes it has to pay. Although PBT doesn't
get the same amount of focus as gross profit, operating profit, and net profit
do, it can still be useful in its own right. Corporate taxation laws can change
and this can end up skewing the net profit that a company earns in a financial
year. For example, [India slashed its corporate tax
rates](https://web.archive.org/web/20200730053904/https://economictimes.indiatimes.com/news/economy/sitharamans-tax-cut-move-why-it-matters-so-much-for-india-inc-economy-and-modi-govt/articleshow/71228078.cms)
for domestic companies from 30% to 22% in September 2019. Some companies in
certain sectors might also enjoy tax incentives from the government for a
specific period of time. In such cases, focusing on PBT might be a good idea.

You should be able to find PBT in the profit and loss statement in an annual
report.


**Profit After Tax (PAT)**, also known as the **Net Profit**, is arguably one
of the most important metrics in an annual report. It is what we usually mean
when we ask "how much profit did the company earn?". PAT is the metric which
tells how profitable a company is after all its expenses are considered and
deducted from the revenue.

Like PBT, you should be able to find PAT in the profit and loss statement in an
annual report.


The PAT margin, also called *net profit margin*, is a widely used metric to
calculate and compare the ability of companies to generate profit.

For the financial year 2019-2020, Abbott India has a PAT margin of
`₹592.93/₹4207.52 = 14.09%` and Pfizer India has a PAT margin of
`₹509.13/₹2335.67 = 21.79%`.

Unlike operating profit, note that we're using *total income*, which includes
*other income* as well, to calculate the net profit and net profit margin.

### Return on Equity (ROE) and Return on Assets (ROA)

**Return on Equity** is a widely used profitability ratio that measures how many
rupees of profit are generated for each rupee of shareholder's equity. It
highlights how efficiently a company uses the shareholder's equity to generate
profits. It can be calculated using the following formula:

Return on Equity = Profit after Taxes / Shareholder's Equity

Depending on the source, we might find a slightly different formula for ROE.

Return on Equity = Profit after Taxes / Average Shareholder's Equity

You can calculate average shareholder's equity by calculating the average of the
shareholder's equity at the beginning and at the end of a financial year.

One might ask — why consider the average of shareholder's equity and not the
total shareholder's equity for a specific financial year?

The following screenshots are from Avenue Supermarts' annual report for the year
2020.


The P&L statement of Avenue Supermarts


The Balance Sheet of Avenue Supermarts


Note 17 from Avenue Supermarts' Annual Report

Avenue Supermarts issued additional shares in the financial year 2020 to comply
with SEBI regulations of bringing down the promoter holding below 75% within 3
years of IPO. This is a one-off event which won't happen regularly. To avoid
presenting skewed ROE numbers, we'll consider the *average* shareholder's equity
rather than the total shareholder's equity. This gives us `(₹11,080.20 +
₹5,588.01) / 2 = ₹8,334.10 crores`. The PAT for the year 2020 was `₹1,300.98`.
This gives us an ROE of `₹1,300.98 / ₹8,334.10 = 15.61%`.

Of course, if the difference between shareholder's equity in successive
financial years isn't driven by one-off events like buybacks or additional issue
of share capital, considering the *average* shareholder's equity may not be
needed.

Similarly, **Return on Assets** can be defined as the amount of profit generated
by a company relative to its total assets. We can use this metric to judge how
well a company utilizes their assets to generate profits. It can be calculated
by using the following formula:

Return on Assets = Profit after Taxes / Total Assets

Just like ROE, we can use *average total assets* instead of just *total assets*
when needed to calculate ROA.

The ROE of Avenue Supermarts for the year 2020 is `15.6%` and the ROA is
`₹1,300.98 / ((₹12,076.45 + ₹7,005.72) / 2) = 13.6%`.

Even though ROE is a popular metric, it's important to understand its quirks and
limitations. Bombay Dyeing & Manufacturing Company Ltd, one of India's largest
producers of textiles, had a ROE of `-124%` in the year 2017, `7.2%` in 2018,
`299%` in 2019, and `269%` in 2020. As you might have suspected, these ROE
figures are misleading (but not incorrect). We'll attempt to showcase the
limitations of ROE as a financial ratio and why it should be used with caution
in cases where the net profit is negative or when the company is in significant
debt.

Besides the definition that we shared above, ROE and ROA can be expressed using
the **DuPont Identity**, also known as the DuPont Method, which breaks down ROE
and ROA into several ratios and presents us with a detailed and an alternative
view.

According to the DuPont method, ROE can be written as

Return on Equity = Profitability Ratio x Efficiency Ratio x Leverage Ratio

Profitability Ratio is the PAT margin we've seen before. The Efficiency Ratio is
`Total Income / Average Assets` and the Leverage Ratio is `Average Assets /
Average Shareholder's Equity`. If you observe closely, the DuPont Identity gives back
the original definition we shared if we cancel out the relevant numerators and
denominators from the above formula. However, by breaking up ROE into 3
different ratios, we can now know how the ROE figures of Bombay Dyeing ended up
getting inflated.


The Balance Sheet of Bombay Dyeing for the year 2019


The P&L statement of Bombay Dyeing for the year 2019

Let's start with the year 2019. We can break down Bombay Dyeing's ROE as

Profitability Ratio = ₹1,228.21 / ₹4,469.98
Efficiency Ratio    = ₹4,469.98 / ((₹5,180.65 + ₹4,146.81) / 2)
Leverage Ratio      = ((₹5,180.65 + ₹4,146.81) / 2) / ((₹182.47 + ₹636.88) / 2)

Return on Equity    = 0.27 x 0.95 x 11.38 = 291%

The difference of 8% may be ignored because ratios were rounded to 2 decimal
places.

Although the profitability ratio and efficiency ratio (also known as **asset
turnover ratio**) are decent, what ends up inflating ROE is the leverage ratio
(also known as **equity multiplier**) which indicates that Bombay Dyeing's
assets are mostly funded through debt rather than equity which is a point of
concern.

Let's assume a hypothetical company called A Ltd. Its accounting equation looks
like `10 = 8 + 2` where assets are 10, equity is 8, and liabilities are 2. Its
leverage ratio is `10/8 = 1.25`. A Ltd decides to take on `20` units of loan to
finance its operations. The equation now looks like `30 = 8 + 22`. The financial
leverage now becomes `30/8 = 3.75`. This would end up inflating the ROE of A Ltd
but that doesn't necessarily mean that its a good thing. Taking on a lot of debt
may or may not pay off. If, however, the profitability ratio and efficiency
ratio increase in the subsequent financial years, taking on debt could be
considered a worthwhile decision.[^1]

The DuPont formula for ROE ends up revealing ROA as well when we multiply the
Profitability Ratio with the Efficiency Ratio. This means that ROA is a function
of a firm's profitability and its asset turnover capability.[^2]

Besides the highlighted limitations in this section, the usual caveats apply.
ROA and ROE are best compared against firms in the same sector with similar
business models.

### Return on Capital Employed (ROCE)

**Return on Capital Employed (ROCE)** is a measure of how much money can a
company generate in the form of profits considering the amount of money invested
in it for the long term.

After reading that definition, one might think, how do we calculate the
"amount of money invested in a company for the long term"?

Let's say you decide to buy a house worth ₹50 lakh. In addition to this cost,
you need another ₹5 lakh rupees for repair and renovation which means you need
₹55 lakh. However, you only have ₹20 lakh for down payment. You decide to borrow
₹30 lakh from your nearby bank as a long term loan and ₹5 lakh from an elder
sibling for completing repair and renovations. The acquisition, repair, and
renovation process takes about 6 months and you're able to pay back the ₹5 lakh
loan you took from your sibling within an year.

If we use the accounting equation in this case, we can say that

Assets = ₹55 lakh (the house)
Shareholder's Equity = ₹20 lakh (the downpayment you made)
Non-Current Liabilities = ₹30 lakh (the long term bank loan)
Current Liabilities = ₹5 lakh (the money borrowed from your sibling)

The long term investment in this company (the house) seems to be ₹50 lakh — the
sum of shareholder's equity (your contribution) and non-current liabilities (the
bank loan). This is what we call **Capital Employed**. It's the amount of money
*employed* by a business to fund its assets and, ultimately, generate profits.

We can define ROCE using the following formula

ROCE = EBIT / Capital Employed

where

Capital Employed = Shareholder's Equity + Non Current Liabilities

One might find Capital Employed defined as `Total Assets - Current Liabilities`
which is just another way of using the accounting equation. We can also use
`Average Capital Employed` to prevent looking at skewed ratios because of abrupt
changes in Shareholder's Equity or Non Current Liabilities.

The ROCE of Bombay Dyeing for the year 2019 is

EBIT = ₹4,429.76 − (₹3,238.08 − ₹489.7) = ₹1,681.38
Average Shareholder's Equity = ((₹182.47 + ₹636.88) / 2) = ₹409.675
Average Non Current Liabilities = ((₹3,399.12 + ₹2,343.83) / 2) = ₹2,871.475

ROCE = ₹1,681.38 / (₹409.675 + ₹2,871.475) = 51.2%

and `8.42%` for the year 2020 as opposed to its ROE of `299%` and `269%` for the
years 2019 and 2020 respectively.

Abbott India's ROCE for the year 2020 is `29.4%` as opposed to its ROE which is
`26.7%`. Avenue Supermarts' ROCE for the year 2020 is `20.4%` and its ROE is
`15.6%`.

It should be apparent that ROCE is a "better" profitability ratio to use
compared to ROE, especially in capital intensive sectors like telecom and auto
where assets being funded by significant debt isn't unusual.

However, ROCE isn't free from limitations. Even though retained earnings is
being counted as part of capital employed, it may not be employed for any
financial activities. A company with high amounts of cash reserves would be
negatively affected when calculating ROCE. This should be apparent in the case
of Abbott India. If we exclude the retained earnings, we'll get a ROCE of `113%`
for the year 2020.


Note 16 of Abbott India, showcasing Other Equity, for the year 2020

We'll compare ROCE to the Weighted Average Cost of Capital (WACC) to judge
whether a company will be profitable in the long run.

### Return on Invested Capital (ROIC)

One of the drawbacks of ROCE, as we saw earlier, was that it considers cash
reservers as part of the capital employed which ends up subduing the ROCE of
Abbott India. Instead of looking at *capital employed*, how about we consider
the *capital invested* in a business? After all, the ability to generate cash
isn't the only thing that matters. A company sitting on huge amounts of cash
isn't necessarily a good thing since the returns generated from that cash is
not going to exceed the cost of capital employed and the expected returns by
shareholders. We'd want a company to make use of that cash effectively and
grow its business better than its competitors.[^6] Efficient capital
allocation matters just as much, if not more, than how capital is employed.
Efficient capital allocation is perhaps one of the most important
responsibilities of the management of a company. It's importance is perhaps
best highlighted by the following excerpt from Warren Buffet's 1987 letter to
shareholders[^3].

> The heads of many companies are not skilled in capital allocation. Their
> inadequacy is not surprising. Most bosses rise to the top because they have
> excelled in an area such as marketing, production, engineering,
> administration or, sometimes, institutional politics. Once they become CEOs,
> they face new responsibilities. They now must make capital allocation
> decisions, a critical job that they may have never tackled and that is not
> easily mastered.

> In the end, plenty of unintelligent capital allocation takes place in
> corporate America. (That's why you hear so much about "restructuring.")
> Berkshire, however, has been fortunate. At the companies that are our major
> non-controlled holdings, capital has generally been well-deployed and, in
> some cases, brilliantly so.

The **Return on Invested Capital (ROIC)**, also known simply as **Return on
Capital (ROC)**, is the measure of profit generated by a company relative to
the amount of capital invested in its business.

Okay, so how do we define what **capital invested** is?

We defined capital employed as `Shareholders Equity + Non-current
Liabilities` but it can also be written as `Total Assets - Current
Liabilities` using the operational approach. We can exclude

- cash and cash equivalents, bank balances, term deposites, and interest
income from cash
- goodwill
- unusual and one-time items

Excess cash sitting in a bank or in debt funds isn't invested in a business
and isn't an operational asset. Goodwill is an intangible asset usually
resulting from the acquisition of a company at a premium value. We exclude
goodwill because it is the leftover premium from the past, not an investment
for future growth. Similarly, other one-time items like asset write downs
aren't included in the capital invested since they are not core operational
assets.

This gives us

Non-operational Assets = Cash and Cash Equivalents - Goodwill - Misc One Time Items
Capital Invested = Total Assets - Current Liabilities - Non-operational Assets

This gives the denominator in the formula for ROIC. Since we are focusing on
the invested capital from an operational standpoint, we'll use operational
profit in the numerator. However, instead of using just EBIT, we'll adjust
EBIT for taxes to get a more standardized version of operating income. This
is known as **net operating income after taxes (NOPAT)**.

ROIC can now be defined as

NOPAT = EBIT x (1 - tax rate)
Capital Invested = Total Assets - Current Liabilities - Non-operational Assets
ROIC = NOPAT / Capital Invested

There's another caveat we should keep in mind when calculating ROIC[^4]. The
NOPAT generated at the end of a financial year won't be because of capital
invested at the end of the same financial year. To account for this timing
difference, the amount of capital invested used in calcuating ROIC will be as
it was at the end of the preceding financial year.[^5]

Let's start with Abbott India. The EBIT for the year 2020 was `₹696.8
crores`. The tax rate can be considered as `25.17%` as mentioned in Note 18
of the financial statements. This gives us a NOPAT of

NOPAT = ₹696.8 x (1 - 25.17%) = ₹521.4 crores


Note 18 from Abbott India's annual report for the year 2020

The capital invested of Abbott India for the year 2019 is

Cash and Cash Equivalents (Note 10) = ₹137
Term Deposits (Note 11) = ₹1,542.07
Interest on Bank Deposits (Note 13) = ₹27.13
Non-operational Assets = ₹137 + ₹1,542.07 + ₹27.13 = ₹1,706.2
Capital Invested = ₹2,940.91 - ₹856.89 - ₹1,706.2 = ₹377.82


Note 10, 11, and 13 from Abbott India's annual report for the year 2020

This gives us a ROIC of `₹521.4 / ₹377.8 = 138%`. The ROIC of Pfizer India
for the year 2020 is `₹351.1 / ₹603.8 = 58.1%`.

Motherson Sumi, an auto ancillary company which is significantly more capital
intensive, has a ROIC of `9.82%` for the year 2020. Of course, this doesn't
mean we can compare Motherson's ROIC with Abbott's. An appropriate comparison
would be with a company like Minda Corporation which is also a capital
intensive auto ancillary company. It's ROIC for the year 2020 was `₹98.7 /
₹761.7 = 12.9%`. One may notice that although Minda Corporation had a
negative PAT for the year 2020, its operational profit was positive. The
reason for the negative PAT seems to an exceptional event which is not
considered when calculating ROIC.


P&L statement of Minda Corporation for the year 2020

Of course, like any other ratio, ROIC has its limitations.

ROIC, and its constituents, are non-standard metrics that we may not find
anywhere in an annual report. We have to calculate NOPAT and Capital Invested
ourselves, manually, to avoid mistakes and incorrect calculations. Although
we considered the timing difference when calculating capital invested, some
stock screening websites may not do so and use capital invested at the end of
the year in question which is incorrect.

ROIC can also mislead investors into preferring asset light companies with
relatively higher ROIC than asset heavy companies with relatively lower ROIC.

[^1]: [How Return on Equity is Deceiving You](https://web.archive.org/web/20201127204930/https://financialmarketseducation.com/how-return-on-equity-is-deceiving-you)
[^2]: [Return on Assets So Useful ... and so Misused](https://web.archive.org/web/20200826080403/https://www.abi.org/abi-journal/return-on-assets-so-usefuland-so-misused)
[^3]: [Warren Buffet's 1987 Letter to Shareholders of Berkshire Hathaway](https://web.archive.org/web/20210206141150/https://berkshirehathaway.com/letters/1987.html)
[^4]: [ROC, ROIC, and ROE: Measurement and Implications](https://web.archive.org/web/20201229135714/http://people.stern.nyu.edu/adamodar/pdfiles/papers/returnmeasures.pdf)
[^5]: [Return on Invested Capital: How to Get It Right](https://web.archive.org/web/20210205082555/https://junto.investments/roic/)
[^6]: [Questions About ROIC & Valuation](https://web.archive.org/web/20210109175057/https://intrinsicinvesting.com/2016/10/18/questions-about-roic-valuation/)