Financial Ratios & Implication
- Credit Rating Agency in India
- Credit Rating
- Financial Ratios & Implication
The computation of various financial ratios based on the Profit & Loss Account and Balance Sheet of a company/business entity and the most meaningful interpretation of the same play a very significant role in any credit rating exercise, although the overall credit analysis encompasses many other factors like business risk, quality of promoters & management, group support, quality of governance practices and industry scenario & outlook. Further, none of the ratios individually reflect the financial risk of an entity in its entirety. Hence, a collective analysis is undertaken to take an overall view of the financial condition of an entity. While the financial ratios are not exhaustive by themselves for the purpose of financial analysis even, these provide an indication about the trend in performance and helps to compare the same with its peers. Generally, for the purpose of financial analysis, the last three years results are considered along with the projections for the tenure of the instrument or for the future two years, whichever is less. The major financial ratios considered for non-financial sectors are as under:
(A) Growth Ratios
The growth pattern in overall revenue of the corporate/business entity over a particular time horizon vis-a-vis the same in the concerned industry indicates ability of the corporate/business entity to hold its market position. While analysing the trend, the extra-ordinary factors, if any, pertaining to the industry (both domestic and global, if there is overseas linkage), economy and/or the corporate/business entity is also considered to assess the sustainability. A corporate may outperform the industry due to its superior brand penetration, better product mix, competitive cost structure, wide reach and so on.
(B) Profitability Ratios
Ability of a corporate/business entity to earn a decent level of profit and sustainability thereof indicates the extent of protection available for servicing debt. While the volume of profit is pivotal vis-a-vis the level of debt, the trend in margin brings a comfort or otherwise for the investors/lenders. The profitability, the ability to mobilize resources in a cost-effective manner and optimum utilization of resources to generate reasonable return are looked at in the context of industry in which it operates, the business model and the peer group.
It may be necessary for an enterprise to invest in capex regularly or in product development for holding its market position. Higher profitability always helps to do the same out of internal generation, rather than depending on outside borrowings. Further, entities with higher profitability have better shock absorbing capacity in case of economic downturn or in case of any eventuality.
EBIDTA margin denotes the operating efficiency of a corporate/business entity without factoring the effect of capital structure. This is the ultimate effect of various factors like capacity utilisation, market share, pricing power, optimum sourcing of inputs, level of technology and so on. However, this ratio is impacted by the credit period it enjoys with its suppliers and the credit period extended to its customers, because these determine the ultimate raw material prices and sale price of products.
PAT reflects the final profit of the corporate/business entity after netting of all revenue expenses, depreciation and interest expenses, tax obligations and extra-ordinary items, if any. Therefore, the PAT margin reflects net earning capacity and this is considerably influenced by core profitability, capital structure and the borrowing cost. Creditworthiness of the promoter group, track record, bargaining power and overall credit quality of the issuer - all play significant role in influencing the borrowing cost. While analysing with reference to peer group and year-to-year comparison, Infomerics takes out the effect of extra-ordinary items. The business entity/corporate having higher PAT margin is viewed more favourably, although the absolute value of PAT is considered equally important particularly when the industry characteristics indicates a low margin high volume nature because from credit perspective PAT in absolute value is important for future capex and debt servicing.
ROCE indicates the efficient deployment/use of resources (both net worth and borrowed funds). This ratio is independent of capital structure and can be compared across industries to evaluate the industry characteristics impacting the earning ability. The ability of an enterprise to consistently generate ROCE higher than its cost of capital speaks favourably about its long-term business viability. ROCE (Operating) excludes the assets which are not ready for revenue generation like Capital Work-in-progress. Infomerics also takes into account the impact on ROCE of an entity’s policy or practice of stretching payments to its vendors and/or other service providers. Stretching vendor payments may be on account of enterprise having higher bargaining power or due to stressed liquidity.
RONW indicates the net returns to equity shareholders. Sometime this ratio appears distorted in case significant amount of equity is infused by way of right issue/public issue or through private placement towards the end of the year.
(C) Leverage and Coverage Ratios
Long-term debt equity ratio and the overall gearing indicate the capital structure of the company and the working capital sensitiveness. An entity, despite of having a comfortable capital structure as reflected in low long-term debt equity ratio, may have high overall gearing due to high level of short-term borrowings to finance working capital due to working capital intensity or improper working capital management. An entity, even after having a moderate capital structure, may be comfortable in debt servicing due to adequate profit level.
Infomerics applies the first five ratios for the past analysis, while the aforesaid first six ratios are used for future analysis purpose. Interest coverage calculated as EBIDTA/Interest Expense shows the adequacy of Cash Operating Profit vis-à-vis Interest expense, while Long-term Debt/GCA and Total Debt/EBIDTA indicate the adequacy of cash profit and EBIDTA to service the debt repayment obligations. For the future, DSCR ultimately reflects the overall debt servicing ability of the entity over a time span of three to five years. Infomerics also does a sensitivity exercise on the projected DSCR anticipating certain probable adverse scenarios to see the flexibility of its financials. Preference dividend coverage ratio is used in case of rating of Redeemable Preference Share which is computed as PAT/Preference Dividend.
An entity with lower leverage typically has higher financial flexibility to raise incremental external capital (debt or equity) for deployment in business or to overcome temporary funding shortfalls. An entity with lower leverage is also better equipped to withstand volatility in cash flow generation in case of economic adversities, unexpected costs, changing consumer habits/preferences, or regulatory changes.
Infomerics calculates Cash DSCR as (Modified Gross Cash Accrual plus Interest) divided by (Loan repayment plus Interest). Modified GCA shall be GCA less expected investment out of GCA (a) for capex and (b) for incremental working capital which is not covered by tied up by bank loans.
While calculating the Cash DSCR, Infomerics shall factor proposed infusion of long term funds into the company by way of promoter’s contribution and or Term loans in the numerator of the Cash DSCR ratio. In such cases, the quantum of fund infusion, source and timelines for the same shall be a key rating monitorable.
(D) Liquidity Ratios
The above are Liquidity ratios are generally used for rating short-term instruments. While the above ratios being above unity signify the ability of the entity to pay off immediate payment obligation (falling due within next 12 months), these ratios are not exhaustive by themselves because large & strong companies sometime lengthen the creditors payment to get the benefit of float and in such cases, these ratios fall below unity and do not meaningfully indicate the actual liquidity position. This is why and even otherwise, the cash flow statements and utilisation of fund-based bank limit are also considered for evaluating the liquidity of a corporate/entity.
Infomerics also takes into account the liquid investments and/or the cash balances, access to unutilised credit lines, any external support for meeting near term maturing obligations, etc. A separate section of Liquidity is made in the Press Release capturing therein a synopsis of the aforesaid liquidity support along with the adequacy or otherwise to meet the near-term debt servicing obligations.
(E) Turnover Ratios
These ratios essentially indicate the efficient management of working capital or otherwise. While the industry related characteristics have an impact on these ratios, the efficiency of the entity in asset deployment is critical for its financial risk profile. The working capital turnover ratio signifies the entity’s efficiency in managing working capital. The other ratios indicate such efficiency with reference to each major current asset and creditors. While lower the ratios are better (in case of ii) to (v), as aforesaid, optimum holding of each type of current asset ultimately gets reflected into a high level of turnover vis-a-vis working capital. While average collection period is a popular and common measure for ascertaining the efficiency of the entity in receivable management, Infomerics feels it important to ascertain the overall inventory management pattern. The higher average finished goods holding period is due to various reasons including competition, obsolescence, major technical innovation, etc., besides the general industry pattern. The average raw material holding period indicates how efficiently the inventory of raw material is managed. Sometimes it may be prudent to source the raw material (imported, indigenous or both) in bulk to optimise the transportation cost and/or to ensure that the critical raw material is always in stock. Average creditors period indicates how the suppliers payments are managed and a higher period may, at times, indicate superior bargaining power. The operating cycle is used as a measure to evaluate the conversion cycle.
Adjustments made to Financial Statements to interpret the financial ratios
Following are some of the common major adjustments made to Financial Statements while calculating &/or interpreting various financial ratios:
i) Net worth represents the tangible net worth and hence, all the intangibles are deducted from the net worth, except bought-out goodwill.
ii) Revaluation Reserve is deducted from net worth.
iii) Deferred Tax Liability is considered as non-interest bearing liability and hence, is excluded in long term debt-equity and overall gearing ratio computation.
iv) Compulsorily Convertible Preference Shares, Compulsorily Convertible Debentures and Share Application Money are included in Net worth. The adjustment of share application money is to be examined as per current regulation wherein a period of only sixty days is provided for allotment, else the same has to be credited back to the investor.
v) Unquoted Equity Investment is considered as non-current asset.
vi) Liability on account of capital goods is shown as long-term liability if there is a tied up loan available against the same.
vii) Capital Advances are added to Capital Work In Progress.
viii) Retention Money Receivable outstanding as on the account closing date:
ix) Interest bearing Advances from Customers &/or Sub-contractors (especially in construction companies) is considered as debt for the purpose of computing Overall Gearing Ratio.
x) Fixed deposits given as margin to banks are shown as a part of Current Investments.
xi) Unsecured Loans from promoter(s) or promoter group subordinated to banks /lender is considered as Quasi Equity (QE) and treated as a part of net worth. However, in case it is found that such unsecured loans have been, in the recent past, partly/fully repaid back to the promoter, these loans may not be treated as networth.
xii) Outstanding bill discounted is added to bank borrowings and the same amount is added to sundry debtors.
xiii) In case of construction companies, Advances from customers are treated as Current Liability and Long-term Liability based on the average tenure of the contracts in hand
xiv) Investments in liquid mutual funds are treated as Current Assets.
xv) Deposits from customers are long-term interest-bearing deposits and hence, are treated as long-term liabilities.
Updated July – 2022 (after Board Meeting dated 31.05.2022)