Personal Financing 103 - Basics of Equity investing

“The key to making money in stocks is not to get scared out of them.” ~ Peter Lynch

Peter Lynch happens to be America’s number one money manager. He believes that average investors can do as well and become experts in their own field as Wall street professions by doing little research.

Everyone who has invested in stock market has lost money at some point or the other. But does anyone highlight or paint across the not – glamorous picture of them?

Absolutely No!

It is okay and totally acceptable to lose money in stock market. If you don’t, you would be scared yourself!

And this, in general, goes as a life lesson.

Never be scared of learning or trying by just a few failures.

Learn from the mistakes you make so you can make use of similar conditions next time to gain money.

Rakesh Jhunjhunwala is an Indian billionaire, investor and trader.

Do you think he never lost money in the stock market? Everyone knows the story of the lakhs of money he made by investing in Titan company.

How many people know he also invested in DHFL and Delta Corp and lost huge amount of money?

Infact, one of the above two companies filed for insolvency proceedings few months back.

Obviously he never got scared of investing in equity market, and nor should we. With proper research and knowledge, an average investor has as good a chance of succeeding at equity market as an industry stalwart.

Coming back to where we left from last time, we shall start with leverage ratios.

Leverage ratios help analyse the level of debt and its subsequent usage for a company. Too much of debt will demand higher interest paid, which will eat into the profit of the shareholders.

Various ratio we look at to analyse the debt level are:

1.       Interest coverage ratio

2.       Debt to equity ratio

3.       Debt to asset ratio

4.       Financial leverage ratio

Take a pen/paper/excel or a mental calculator before we move ahead.

Taking the example of the same company that we took last time, here are the financials of the company.

1.       Interest coverage ratio = Earnings before interest and tax/Interest payment

Earnings before interest and tax = EBITDA – depreciation and amortization

And interest payment = finance costs

2.       Debt to equity ratio (D/E ratio) = total debt/total equity

Total debt = short term debt + long term debt

D/E ratio: 843.3/13627.01

Here the debt is not high compared to the equity, which is why the interest coverage ratio also comes out to be high.

3.       Debt to assets ratio = Total debt/total assets

= 843.3/21394

4.       Financial leverage ratio = Average total assets/average total equity

= 1955/1211.2

 Certain information which can be derived from the above ratios is:

1.       Interest coverage ratio implies how easily can interest be paid off via earnings. Low interest coverage means high debt burden (and hence high interest payment) and greater possibility of default.

2.       Low D/E ratio implies less leverage and stronger stability.

3.       If high amount of debt is used to finance the assets i.e. high debt to assets ratio, it implies high leverage and more risk.

4.       High financial leverage again implies high leverage. 

Moving onto operating ratios, these help in indicating the operational efficiency of an organization. 

There are seven kinds of operating ratios:

1.       Fixed assets turnover ratio

2.       Working capital turnover ratio

3.       Total assets turnover ratio

4.       Inventory turnover ratio

5.       Inventory number of days

6.       Receivable turnover ratio

7.       Days sales outstanding (DSO)

We shall cover first three ratios in the current blog post.

1.       Fixed asset turnover ratio = operating revenues/total average asset

= 343.7/614.85

Please note that total average assets considered above are average of fixed assets only

We can understand a lot if we only interpret the meaning of the formula correctly. Fixed asset turnover implies the revenue in comparison to the investment in fixed assets. High value implies efficient usage of the assets to generate revenue.

2.       Working capital turnover ratio = revenue/average working capital

 Working capital = current assets-current liabilities

 = 3437/672 = 5.11 times

 Working capital implies the capital required for day to day operations. Above ratio implies the  revenue generated from every unit of working capital. High ratio implies better sales with respect to  the money used to fund those sales.

3.       Total assets turnover ratio = operating revenue/total average assets

= 3437/1955

=1.75

This is similar to fixed asset turnover ratio with the exception that it includes total assets i.e. current and fixed assets.

As discussed, none of the above ratios have any meaning on standalone basis. All the ratios are looked at either with respect to the industry standards or in comparison to peers in the same industry.

We shall leave the remaining four operating ratios for a self assessment. Here is how they can be calculated:

Inventory turnover ratio = cost of goods sold/average inventory

Inventory number of days = 365/inventory turnover

Accounts receivable turnover ratio = revenue/average receivables

Days sales outstanding = 365/receivables turnover ratio

Does this thought ever come across “Will I actually do the entire analysis for all the stocks I invest in? This isn’t my full time job, please understand!”

You will smile when you know the answer to your question is NO. But is important to understand the terminology before you take the plunge. You will not do the entire analysis every time but set across your own benchmarks for stock selection by the end of next two posts.

In case you wish to, you may send across the answers to self - assessment ratios at kumar.nidhi90@gmail.com.

Take a deep breath and relax!

Happy Thursday!

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