Financial Ratio Analysis
In credit proposals, Ratio analysis plays a significant role in analysing the financial health of units. Structuring the ratios in a proper manner not only results in gauging the performance of the unit, but also in analysing its exact financial needs.
let us understand various Profitability ratios along with rationales.
1. Operating Profit / Net Sales (%):
This ratio gives clue about the profitability of the unit from its core operations.
Rationale: It is to understand whether profitability reported by the unit is on account of its core operations or from non operating income.
2. Profit Before Tax (PBT) / Net Sales (%):
Indicates Profitability levels. It gives an indication regarding percentage of profit reported by the unit out of total income in a particular financial year
Formula for PBT: Net Sales (-) Operating expenses (-) Interest (+) Non operating income (-) Non operating expenditure.
For example, if PBT is Rs 10/- out of net sales of Rs 100/-, then the unit has a profitability of 10% in its business.
Rationale: PBT is arrived after considering Non operating income and Non operating expenditure. It is to understand whether profitability reported by the unit is on account of its core operations or from non core operations.
3. Operating cost to sales:
Operating cost is sum total of expenditure incurred from the stage of raw materials purchased to selling, General and administration expenses.
Rationale: This ratio is important in understanding the total amount of cost involved out of per unit sale. For example, an Operating cost to sales of 0.75 indicates, that the unit is incurring an amount of Rs 75/- in the form of operating costs while generating a revenue of Rs 100/-
4. Long Term Loans /Earning Before Interest, Depreciation, Taxation and Amortization (EBIDTA):
It indicates the comfortable level of EBIDTA to take care of term loan repayment obligations.
Rationale:Lower the ratio, greater is the comfort. If the ratio is low, it indicates that unit is not excessively indebted and is able to fulfil its debt obligations. Conversely, if the ratio is high, it indicates that company is heavily burdened with debt.
5. Interest Coverage Ratio (ICR) = Profit before Depreciation, Interest and Tax (PBDIT) / Interest):
It determines the cushion available in the hands of the unit out of surplus generated from its operations to pay interest on its outstanding debt. This ratio explains the sufficiency of available funds (PBDIT) in the hands of the unit to take care of interest obligations.
Rationale: This signifies that the unit has to generate sufficient income to meet its interest obligations, even when the business prospects are adverse.
A lower ICR indicates that less operating profits are available to meet interest payments and that the unit is more vulnerable to volatile interest rates. Therefore, a higher interest coverage ratio is desirable which indicates stronger financial health.
6. Return on Equity (ROE) %:
ROE is calculated as a ratio of net profit to the equity. It indicates what is the percentage of return, the equity share holders are deriving from their investment made in the business.
Rationale: ROE represents the capacity of the unit to serve its equity holders. Higher the level, higher is the return derived by share holders.
7. Debt Service Coverage Ratio (DSCR):
‘Debt’ means maturing term obligation within a year viz., instalment repayable during a year under all term loans/deferred payment guarantees and ‘service’ means cash accruals consisting of net profit plus depreciation and non-cash expenses written off.
This ratio has to be calculated for the entire tenor of term loan. While calculating DSCR, existing term loan and its repayment should also be considered along with proposed term loan. Apart from this, any other term loan sanctioned by any other financial institution should also be considered.
Gross DSCR = [PAT + Depreciation and other non cash expenses** + Interest on term loan] / [Annual Principal instalments + Interest on term loan]
Net DSCR = [PAT + Depreciation and other non cash expenses**] / [Annual Principal instalments]
** Amortization, unrealized gains, unrealized losses etc.
Average Gross DSCR: It is calculated by dividing sum total of cash + Interest on term loan for the entire period of term loan with sum total of Annual Principal instalments + Interest on term loan for the entire period of term loan.
Rationale: DSCR is most important, as it indicates the ability of an enterprise to meet the liabilities (by way of instalments of Term Loans and Interest) out of cash accruals generated and forms the basis to fix repayment schedule in respect of the Term Loans sanctioned
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