Chapter 03 · Reading a company's numbers
A small set of ratios
A ratio is a comparison that lets you read a large company and a small one in the same units. Four families cover most of what a first reading needs: profitability, leverage, liquidity, and the price you are being asked to pay. More ratios do not make the reading wiser if you cannot say what each one would change your mind about.
Profitability: how hard the capital works
Return on equity is profit attributable to shareholders divided by shareholder equity. If a company earned ₹150 crore on equity of ₹1,000 crore, the return is 15%. That number mixes three things: how profitable each rupee of sales is, how many sales each rupee of assets produces, and how much of the assets are funded by debt rather than by owners. A 15% return funded mostly by debt is a different risk from a 15% return funded by owners. Do not rank two companies on return on equity alone.
Operating margin, which you already met, ignores the funding and asks whether the business itself is profitable. Use both. A high return on equity with a thin, shrinking margin is often leverage doing the work.
Leverage: whose money is at risk
Debt to equity, or simply total borrowings next to equity, says how much of the funding can demand its money back. Interest cover — operating profit divided by interest — says whether this year’s operations can pay the coupon. A company with debt of ₹400 crore, equity of ₹1,000 crore, operating profit of ₹170 crore and interest of ₹30 crore covers interest about 5.7 times. That is comfortable in a stable year and less informative in a year when operating profit can halve. Compute the cover on a bad year’s profit, not only on the year the company printed in the annual report.
Liquidity: can it pay the bills that are due soon
Current assets divided by current liabilities is a rough test of the next twelve months. A ratio of 1.6 means current assets are 1.6 times the bills due inside a year. Inventory that nobody wants, and receivables that customers are late on, inflate the ratio without helping. Subtract those if the notes make you doubt them, and look at cash and short-term investments as a separate pile. A company can have a fine current ratio and still be one large customer default away from a problem.
Price: what the market is charging for the claim
| Ratio | Compute | A disciplined reading |
|---|---|---|
| Price to earnings | Share price divided by earnings per share | You are paying this many rupees for one rupee of recent earnings. It says nothing about whether those earnings will last. |
| Price to book | Share price divided by book value per share | Useful where assets are the business, as in a bank or a property firm. Weak where the value is a brand the balance sheet barely records. |
| Dividend yield | Dividend per share divided by price | The cash yield at today’s price. A very high yield can mean a generous board or a price that has already fallen because the dividend is about to be cut. |
Suppose earnings are ₹6.60 a share, the book value is ₹50, the dividend is ₹2, and the price is ₹132. Price to earnings is 20, price to book is 2.6, and the dividend yield is about 1.5%. None of those is cheap or expensive by itself. They are expensive or cheap beside the same company’s history, beside a few genuine peers, and beside the growth and the debt you already wrote down. A peer that earns a 20% return on equity with no debt is not comparable to one that earns 15% with interest cover of 1.5, even if they share an industry label.
What to remember
- Return on equity mixes operations and debt. Read the margin and the borrowings beside it.
- Interest cover on a good year flatters a cyclical business. Recompute it on a weak year.
- A current ratio full of stale stock is not liquidity.
- Price multiples are a price, not a verdict. Compare them with peers you would actually confuse with this company.
- If a ratio will not change a decision you can name, do not collect it.