In this post I intend to discuss the third group in this series which is Cash Flow Ratios and would cover Debt to Equity Ratio, Interest Coverage Ratio, Current Ratio or Working Capital Ratio and lastly Quick Ratio or Acid Test.
In Fundamental Analysis, I rate this group above all others, especially if I am considering investment for longer time frame.
In a nut shell, these ratios would tell you in absolutely unambiguous terms that if the company is likely to remain in business in next 5 to 10 years time or not.
D/E (Debt to Equity) Ratio
First in this series is Debt to Equity Ratio, which is self explanatory. This ratio in plain words means how much debt (total borrowings by a company) can be paid by utilising shareholders money.
As your intuition must be telling you, lower this value, lesser will be the risk in your investment.
Many of you, who might be tracking Alok Industries would know that its share sky rocketed after its acquisition by Reliance.
However, this price momentum fooled many as finally the share price settled at around Rs 20/-. Lets check its D/E ratio its -1.35, what a negative ratio?
How can a ratio be negative? Its because, the value of the company is lesser in relation to the loans it has taken and it means extremely risky investment and probably this is what is keeping its share prices locked in the present range for more than six months now. What about Indiamart then?
Its D/E ratio is Zero, signifying it is a debt free company and just see the price of its share, it is trading at Rs 7435/-.
Therefore, we can safely assume that due to its sound financials more and more investors are interested in this share driving its share price higher and higher.
Pro Tip:- D/E value lesser than 1 would be ideal. Between 1 to 2 = Acceptable risk and more than 2 could be considered as risky.
However, this is sector specific and best comparison is always between peers from the same segment.
Interest Coverage (I/C) Ratio
Taking loans for expansion or to boost production is a good thing. However, if the interest on loans taken starts to threaten the very existence of the company, it becomes worrisome for the investors.
This ratio tells us about the capability of the company to service interests on the loans it has taken by generating profit and can be easily calculated by dividing the EBIT (Earnings Before Interest & Taxation, this too has been covered in greater detail in previous posts) by the interest for a particular quarter or a year.
Higher the ratio, more stable the company is financially.
This too varies greatly from sector to sector and hence, ideally, should be compared within the sector. The I/C for Alok Industries is -0.15.
The negative sign indicates that it is a loss making company and the ratio of less than one indicates that it cannot even pay the interest accrued on the loans taken by it based on revenue generation from core business.
While on the other hand for Indiamart this ratio is a healthy 59.1
Pro Tip: — Higher I/C ratios indicate productive or good loans which are contributing towards more and more income, while lower ratios mean that the company is dependent on loans for day to day operations. Generally a I/C Ratio below 1.5 is considered risky.
Current Ratio or Working Capital Ratio
This is obtained by dividing current or short term assets (such as cash, money expected from others, finished goods and inventories etc) by short term liabilities (such as salaries, rents, short term debts, instalments of longer period debts or any other payments which are required to be made in shorter time frame).
I guess, it is quite clear that any company which has more short term assets than its liabilities would not face cash crunch to continue its core businesses and hence would be a sound investment.
Lets again compare Alok Industries ratio of 0.64 to Indiamart’s 4.41, who do you think is a cash rich company? Of course, investors would prefer Indiamart and this is reflected in its high share price, which is more than five times its Intrinsic Value.
Pro Tip:- A Current Ratio of about 1 is considered ideal. If this is too low, it reflects company’s weak financial condition but if it is too high say around 10, it would reflect company’s inability to utilise available cash productively and is to be seen with concern by investors.
What is equally important is how over the time, this ratio has been increasing or decreasing and that would determine its current share price.
If any one of you had been tracking Future Retail, it’s falling Current Ratio since 2016 would have indicated its downward price momentum well in advance.
Quick Ratio or Acid Test
It is almost similar to Current Ratio and the only difference is to determine as of today or for a very short time ahead in future, if the company will be solvent or not.
For this purpose, Quick Ratio takes into account only those assets which can be easily converted in the cash to pay off immediate liabilities.
For example, if there are considerable unsold goods or unused inventories which cannot be liquidated in a short time, the value of these assets will be deducted from the Current Assets to calculate Quick Assets and the ratio of Quick Assets to Quick Liabilities is called as Quick Ratio or Acid Test Ratio.
Continuing our comparison of Alok Industries vs Indiamart. Quick Ratio for Alok Industries is 0.30 vs 4.41 of Indiamart.
If you observe carefully, you would notice that both Current and Quick Ratios for Indiamart are 4.41 indicating it would have no difficulty in liquidating its inventories and unsold goods on the other hand for Alok Industries Current Ratio of 0.64 drops to 0.30 as Quick Ratio signifying that Alok Industries would have to discard half of its current assets (probably inventories and unsold goods) while calculating Quick Assets.
Pro Tip:- Similar to Current Ratio, Quick Ratio of near around 1 is considered most ideal and a ratio of less than 1 raises red flag indicating that the company would have trouble meeting its liabilities in short frame of time.
Guys, it is just a five to six minutes read per week, therefore, please read through the entire post.
I try my best to keep it as simple and systematic as possible and if you read any of the post you would see that it is mostly common sense.
Then why do we even bother to learn about various terms? Its just that, if you understand these terms or jargon well, your job of analysis becomes extremely easy as most of these values are freely available on free website then why work extra.
I personally prefer screener.in as here with one click you can find all the ratios you are interested in and you can also customise which ratios to be displayed while searching for any share.
This is a guest post by Dhruva Shrivastava.