Analysing the balance sheet - key ratios, calculations

So, you now know how to read through the balance sheet of a company. What is the purpose of all of those numbers though? Well, they can be used to calculate many useful ratios. That’s just what we’re going to see in this chapter.

Let’s take up the balance sheet of Hindustan Unilever limited and thoroughly analyse the data using various financial ratios and numbers. This analysis will give us some much needed information on the company’s performance and standing. 

For your reference, here’s the snapshot of Hindustan Unilever Limited’s balance sheet for the year 2019-2020. Now, without any further ado, let’s get to analysing the balance sheet. 

Important financial numbers, ratios, and their calculations

As you know by now, there are plenty of financial ratios and calculations. However, not all of them might be of use to you, as an investor. So, we’ll be looking at only the key ratios and financial numbers that can help you take better investment decisions.

1. Current ratio

The current ratio is a liquidity ratio that measures a company's ability to pay off its short-term debts and obligations, which are typically due within one year. It tells you whether the company has enough current/liquid assets to repay its short-term dues. The formula for current ratio is as follows.

Current ratio = current assets ÷ current liabilities

 

For HUL, the total of current assets comes up to Rs. 11,908 crores, while the total of current liabilities comes up to Rs. 9,104 crores.

Current ratio for HUL (for the year 2019-2020) = 1.30 

(Rs. 11,908 crores ÷ Rs. 9,104 crores)

A current ratio greater than one (like in this case) indicates that the company has the financial resources to remain solvent in the short-term time frame.

2. Return on equity (ROE)

One of the most widely used ratios in fundamental analysis, the return on equity ratio helps you determine a company’s ability to make profits using just the funds from its shareholders. It gives you a fair idea of the returns a company generates for every hundred rupees invested by the shareholders. 

The higher the ROE, the more efficient the company is at using the shareholders’ funds to generate profits. This ratio is expressed in percentages and can be calculated using the following formula.

Return on equity (ROE) in % = (PAT ÷ shareholders’ equity) x 100

Let’s take a look at the ROE of Hindustan Unilever Limited for the year 2019-2020. 

ROE of HUL (for the year 2019-2020) in % = 83.90% 

[(Rs. 6,738 crores ÷ Rs. 8,031 crores) x 100]

Here, the shareholders’ equity of Rs. 8,031 crores of HUL includes the values of both equity share capital (Rs. 216 crores) as well as other equity (Rs. 7,815 crores). 

A return on equity of 83.90% essentially means that the company generated Rs. 83.90 rupees for every hundred rupees invested by the shareholders.

3. Return on assets (ROA)

The return on assets ratio gives you an idea of how efficient a company is at using its assets to earn revenue. A high return on assets indicates that a company is good at utilising its assets to generate earnings. It is denoted in percentages and is calculated using the following formula. 

Return on assets (ROA) in % = (net income ÷ total average assets) x 100

Where, 

Total average assets = (total assets of the current year + total assets of the previous year) ÷ 2

Here, in the case of HUL, total average assets = Rs. 18,733.5 crores

(Rs. 19,602 crores + Rs. 17,865 crores) ÷ 2

You’ll find the net income in the P&L statement as the Profit After Tax (PAT). For HUL, it is Rs. 6,738 crores (see image below).

Now, let’s apply the formula to calculate Hindustan Unilever’s return on assets for the year 2019-2020. 

ROA of HUL (for the year 2019-2020) in % = 35.96% 

(Rs. 6,738 crores ÷ Rs. 18,733.5 crores) x 100 

4. Return on capital employed (ROCE)

Another very popular profitability ratio used by investors, the return on capital employed determines a company’s profitability with respect to the overall capital employed by it. Unlike ROE, where only shareholders’ funds are included, ROCE also takes into consideration a company’s debt obligations. 

The higher the ROCE, the better a company’s profitability is. The ratio is expressed in percentages and can be calculated using this formula.

Return on capital employed (ROCE) in % = [EBIT ÷ overall capital employed] x 100

Where, 

Overall capital employed = total assets - current liabilities

5. Debt to equity ratio

One of the most popular leverage ratios, the debt to equity ratio determines the proportion of debt to that of the equity in a company. A debt to equity ratio greater than 1 essentially means that a company has more debt than equity, while a ratio lower than 1 signifies that the equity portion is more than debt. A debt to equity ratio of 1 indicates that a company has equal portions of debt and equity. 

Here’s how you can calculate the ratio. 

Debt to equity ratio = total liabilities ÷ total equity

You can find these values in the balance sheet of a company itself. Take a look at the screenshot below for more details.

So, the debt to equity ratio of Hindustan Unilever Limited. 

Debt to equity ratio of HUL (for the year 2019-2020) = 1.44 

(Rs. 11,571 crores ÷ Rs. 8,031 crores)

6. Debt to asset ratio

Similar to the debt to equity ratio, this ratio determines the proportion of debt to that of the assets of a company. It is a leverage ratio that gives you information on the percentage of assets of a company that are financed through debt. The lower the debt to asset ratio, the better. 

Calculating this ratio can be done using this formula. 

Debt to asset ratio % = (total liabilities ÷ total assets) x 100

Applying this formula to the data available in the balance sheet of HUL, we get 

Debt to asset ratio of HUL (for the year 2019-2020) in % = 59.02% 

[(Rs. 11,571 crores ÷ Rs. 19,602 crores) x 100]

A debt to asset ratio of 59.02% indicates that around 59.02% of assets owned by HUL is financed using debt capital.

7. Equity multiplier 

A variation of the debt to asset ratio, the equity multiplier determines the amount of assets that are funded by shareholders’ equity. The lower the equity multiplier, the better. It can be calculated using the following formula. 

Equity multiplier = total assets ÷ total equity

Going by this formula, the equity multiplier of HUL is as follows. 

Equity multiplier of HUL (for the year 2019-2020) = 2.44 

(Rs. 19,602 crores ÷ Rs. 8,031 crores)

This effectively means that for every rupee of equity, HUL has Rs. 2.44 worth of assets. 

8. Fixed assets turnover

Fixed assets turnover establishes a relationship between the operating income of a company and its fixed assets. This ratio is an indicator of efficiency and is used to determine just how much sales a company generates using its fixed assets such as plant, equipment, machinery, and capital work-in-progress (CWIP). The higher the fixed assets turnover, the better. The fixed assets turnover can be calculated using this formula.

Fixed assets turnover = revenue from sales ÷ fixed assets

Where,

Fixed assets = (property/plant/equipment + capital work-in-progress (CWIP) + goodwill + other intangible assets)

In the case of HUL, the fixed asset turnover is as follows. 

Fixed assets = Rs. 5,569 crores 

(Rs. 4,625 crores + Rs. 513 crores + Rs. 36 crores + Rs. 395 crores)

Fixed assets turnover = 6.87 

(Rs. 38,273 crores ÷ Rs. 5,569 crores) 

9. Working capital turnover 

Funds that a company requires to run its everyday operations are commonly collectively known as working capital. The working capital turnover ratio shows just how much revenue a company makes for every rupee of working capital. A high working capital turnover is favourable, since it means that a company generates more revenue per rupee of working capital. It can be calculated using the following formula. 

Working capital turnover = operating revenue ÷ average working capital

Where, 

Working capital = current assets - current liabilities 

Average working capital = (working capital of the current year + working capital of the previous year) ÷ 2

Now that you’re aware of the formula, let’s put it to use to find out the working capital turnover of HUL. 

Working capital of HUL (for the year 2019-2020) = Rs. 2,804 crores 

(Rs. 11,908 crores - Rs. 9,104 crores) 

Working capital of HUL (for the year 2018-2019) = Rs. 3,021 crores 

(Rs. 11,374 crores - Rs. 8,353 crores)

Average working capital of HUL = Rs. 2,912.5 crores 

[(Rs. 2,804 crores + Rs. 3,021 crores)÷ 2]

Working capital turnover = 13.32 

(Rs. 38,785 crores ÷ Rs. 2,912.5 crores) 

A working capital turnover of 13.32 effectively means that HUL generates Rs. 13.32 of revenue for every rupee of working capital. 

10. Inventory turnover ratio

The inventory turnover ratio determines the number of times a company has managed to sell and replenish its stock of finished goods. It is typically calculated for a specific time period. The formula for calculating inventory turnover ratio is as follows. 

Inventory turnover ratio = cost of goods sold (COGS) ÷ average inventory

Some entities may use their revenue from sales instead of the COGS to calculate the inventory turnover ratio. In that case, the formula becomes:

Inventory turnover ratio = revenue from sales ÷ average inventory

Hindustan Unilever Limited has used the second formula. So, the inventory turnover ratio has been calculated like this.

Average inventory of HUL = Rs. 2,529 crores 

[(Rs. 2,636 crores + Rs. 2,422 crores ) ÷ 2]

Inventory turnover ratio of HUL = 15.13

(Rs. 38,273 crores ÷ Rs. 2,529 crores) 

This shows that in a single financial year (2019-2020), HUL has managed to sell and replace its entire stock of finished goods approximately 15 times. 

11. Inventory number of days

Inventory number of days determines the time taken by a company to convert its inventory into cash through sales. A lower value for ‘inventory number of days’ means that a company is able to quickly sell its goods for cash, which effectively means that its goods are in demand. You can calculate it using the following formula. 

Inventory number of days = 365 ÷ inventory turnover ratio

For HUL, the inventory number of days is as follows. 

Inventory number of days of HUL (for the year 2019-2020) = 24.12 (365 ÷ 15.13)

This shows that it takes approximately 24 days for Hindustan Unilever to convert its inventory into cash. 

12. Accounts receivable turnover

The accounts receivable turnover is very similar to the inventory turnover ratio. It determines the number of times a company collects cash from its debtors. A high accounts receivable turnover is favourable since it means that a company collects cash frequently. The ratio can be calculated using this formula. 

Accounts receivable turnover = revenue from sales ÷ average accounts receivables

Let’s take a look at how HUL has performed in the current year. 

Average accounts receivable = Rs. 1,359.5 crores 

[(Rs. 1,046 crores + Rs. 1,673 crores) ÷ 2]

Accounts receivable turnover of HUL (for the year 2019-2020) = 28.15 

(Rs. 38,273 crores ÷ Rs. 1,359.5 crores) 

This indicates that HUL has collected cash from its debtors approximately 28 times in the year 2019-2020.

13. Average collection period

The average collection period determines the time it takes for a company to collect cash from its debtors. A lower average collection period is favourable since it effectively means that the company is able to collect cash quickly. It can be calculated using this formula. 

Average collection period = 365 ÷ accounts receivable turnover

For HUL, the average collection period for the year 2019-2020 is 12.96 (365 ÷ 28.15). This indicates that the company takes roughly 13 days to collect payments from its debtors.

Types of Balance Sheets

There are different types of balance sheets you may come across while performing fundamental analysis for the companies you are interested in. Here is a closer look at the common types of balance sheets.

• Common size balance sheet:

A common size balance sheet shows the information about assets and liabilities, as well as information about each item as a percentage of total assets or total liabilities, as the case may be.

• Vertical balance sheet:

A vertical balance sheet is a document that shows the information pertaining to assets, followed by liabilities, in a single column.

• Comparative balance sheet:

A comparative balance sheet contains side-by-side information about the company’s assets and liabilities over different periods of time.

Wrapping up

Well, that wraps up our chapter on the ratios based on the balance sheet of a company. But this certainly isn’t the end of the road, because we have the cash flow statement to consider. What does that statement show? And what are the ratios associated with that statement? These are some of the things that the next chapter in Smart Money will deal with.

A quick recap

• The current ratio is a liquidity ratio that measures a company's ability to pay off its short-term debts and obligations, which are typically due within one year.
• Current ratio = current assets ÷ current liabilities
• One of the most widely used ratios in fundamental analysis, the return on equity ratio helps you determine a company’s ability to make profits using just the funds from its shareholders. It gives you a fair idea of the returns a company generates for every hundred rupees invested by the shareholders.
• Return on equity (ROE) in % = (PAT ÷ shareholders’ equity) x 100
• The return on assets ratio gives you an idea of how efficient a company is at using its assets to earn revenue.
• Return on assets (ROA) in % = (net income ÷ total average assets) x 100
• The return on capital employed determines a company’s profitability with respect to the overall capital employed by it. Unlike ROE, where only shareholders’ funds are included, ROCE also takes into consideration a company’s debt obligations.
• Return on capital employed (ROCE) in % = [EBIT ÷ overall capital employed] x 100
• The debt to equity ratio determines the proportion of debt to that of the equity in a company. A debt to equity ratio greater than 1 essentially means that a company has more debt than equity, while a ratio lower than 1 signifies that the equity portion is more than debt.
• Debt to equity ratio = total liabilities ÷ total equity    
• Debt to asset ratio % = (total liabilities ÷ total assets) x 100
• Equity multiplier = total assets ÷ total equity
• Fixed assets turnover = revenue from sales ÷ fixed assets
• The working capital turnover ratio shows just how much revenue a company makes for every rupee of working capital.
• Working capital turnover = operating revenue ÷ average working capital
• Inventory turnover ratio = cost of goods sold (COGS) ÷ average inventory   
• Inventory turnover ratio = revenue from sales ÷ average inventory   
• Inventory number of days = 365 ÷ inventory turnover ratio
• Accounts receivable turnover = revenue from sales ÷ average accounts receivables
• Average collection period = 365 ÷ accounts receivable turnover