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The Lion King | 15
tells you exactly how much is being returned to
shareholders for the investment they have made
in the company. The higher the RoE, the better. It
is calculated as
Profit Attributable to shareholders x 100
Average shareholders’ Funds
Other profitability ratio’s that will give insight to how
well management is running the company include.
b. Gross Profit Margin (GPM):
This measures profit-
ability rate after excluding the cost of sales from
revenue. The higher the GPM, the better. It is
calculated as
Gross Profit x 100
Sales
c. Operating Profit Margin (OPM):
This relates a
company’s profits from core operations to its
sales in an attempt to reveal the proportion of
sales not appropriated as preliminary (selling,
distributing, advertising/marketing expenses)
and sales costs. Operating profit is synonymous
with EBIT (Earnings Before Interest & Tax). Analysts
are fond of EBIT because it is a variable that can
hardly be manipulated by management. As a
result, it helps in making reliable forecasts about
future performance. The higher the OPM, the
better. It is calculated as
Operating Profit x 100
Sales
d. Net Interest Margin: Used to assess the perform-
ance of banking institutions. It is an attempt to
evaluate a bank’s ability to generate better
returns on its interest bearing assets than its
payments on interest bearing liabilities. The
higher the NIM, the better. It is calculated as
Net Interest Income x 100
Average Interest earning assets
Please note:
Net Interest Income is Interest and
discount Income less Interest Expense, while
previous and current interest bearing assets are
averaged for consistency.
Generally, the higher a company’s profitability ratio;
vis-à-vis previous periods, its competitors or industry
average, the better.
LIQUIDITY RATIOS
This is a measure of how easily or quickly a
company can convert its short-term assets into cash
with a view to meeting its maturing obligations like
repaying creditors. These ratios depict the financial
flexibility of a company and, its exposure to risk.
Generally, the higher the value of the ratio, the
larger the margin of safety the company possesses
to cover its liabilities. Most liquidity ratios are
expressed as ‘times’.
Some important liquidity ratios are discussed in turn.
a. Current ratio:
It establishes a relationship
between a company’s short-term assets and
short-term liabilities. It is calculated as
Current assets (times)
Current Liabilities
b. Acid test Ratio:
This establishes a relationship
between a company’s easily convertible short-
term assets and its short-term liabilities. In calcu-
lating it, the company’s inventories are removed
from the current assets. It shows how well the
company can cope with a financial emergency.
It is calculated as
Current assets –stocks (times)
Current Liabilities
c. Inventory Turnover:
An indication of the number
of times stock will be sold or replaced to achieve
the sales revenue. If you track this ratio over a
period of time, it can be an early warning for an
improvement or deterioration in the company’s
market position. Many analysts use it to predict
changes in revenue for the next period. The
lower, the better. It is calculated as
Sales
(times)
Average Inventory
Other liquidity ratios include working capital turno-
ver (Sales/working capital), Accounts receivable
turnover (Net credit sales/Average accounts receiv-
able), and Accounts payable turnover (Net credit
purchases/Average accounts payable).
SOLVENCY RATIOS
They are used to evaluate how well a company can
meet its long-term maturing financial obligations.
They measure long-term financial risk regarding its
ability to generate sufficient profits to meet its inter-
est payment obligation as well as repayment of the
principal sum on maturity.
Investors believe that companies with higher debt
levels tend to be riskier. This may not always be
true, as debt may bring some level of efficiency in
the use of overall capital. The important thing is to
determine an optimal mix of debt and equity in a
company’s total funding pool. Below are the major
ratios in this category.
a. Total Debt to Asset Ratio:
It measures the propor-
tion of company debts to its asset base. It helps
investors understand the chances of recoup-
ing their invested capital in the event that the
company gets liquidated. The lower the ratio,
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