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Tuesday, 6 November 2012

A quick guide to financial ratios

Some key ratios to help you understand a company's financial health.

While the price to earnings ratio is often the first port of call when people are gauging a company's investment worthiness, there are many other ratios that can give investors a diagnosis of a firm's investment potential. 

Let's start with two ratios that reveal the profitability of a company. 

Gross (operating) profit margin - First calculate operating profit. That is sales less operating costs. That includes all costs - raw materials, cost of purchases, depreciation, cost of personnel, transport, etc but it does not include finance costs, investment income or tax. The operating margin is worked out by dividing net sales by the company's operating profit. The margin tells investors how profitable the company's sales are. If a company has an operating margin of 10%, you know that for every R10 of sales, there is a rand of profit. Some companies, such as Masonite, have margins of less than 10%, while PPC in the same industry boasts a margin of three times that.

Some analysts prefer to take out depreciation, a non-cash item. They talk about earnings before interest, tax, depreciation and amortisation (Ebitda).

Net profit margin - the net profit is the company's bottom line . It is the profit after expenses such as finance costs, income on investments and after tax. Sometimes a company does not own 100% of the companies it controls. It therefore subtracts the minority share of profits of such subsidiaries before striking net profit attributable to shareholders. Net income can be related to sales and and to shareholders' funds.

Next up are two ratios dealing with the dividends paid by a business. 

Dividend yield - the dividend yield is calculated by taking the annual dividend paid by a company, dividing the figure by the company's share price, and multiplying the result by 100 to obtain a percentage. It is useful because it can be compared to interest on investment funds. The dividend yields of quality companies are often as low as 2%. That is because the dividend is expected to grow apace. If there is uncertainty about future dividends, the share price goes down and the yield rises. While a high dividend yield can indicate an uncertain outlook, it can also indicate a bargain or an under-valued shares.

Dividend cover  - This ratio is calculated by dividing the company's earnings (net profit) per share by the dividend. It is useful because it shows how well the dividend is covered by earnings. A company with a dividend cover of four is more likely to be able to maintain the dividend than one where the cover is just over one. The higher the cover, the safer the dividend. Media conglomerate Naspers has the highest dividend cover of all JSE-listed companies, sitting at 7,2 times. A dividend cover of two or more is considered safe, while anything below 1,5 times is generally risky, according to analysts. 

Finally, here's a look at two balance sheet ratios.

Return on assets - used by a company's management to determine whether it should go ahead with a project or not, this ratio is calculated by adding net profit and interest expenses and dividing the result by total assets (multiply by 100 to get the percentage). If the return is above the rate at which a business can borrow money from a bank, then a project is worth undertaking.

Return on equity - perhaps the most important ratio an investor should consider, the return on equity illustrates how much an investor receives in growth for every rand invested. The return on equity is calculated by dividing net profit by total shareholders' equity in the business (and multiplying by 100). If the answer is 10%, for example, then 10c is returned for every rand invested in the company. Of course, the higher the percentage, the better.

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