All about Combined Ratios

Financial ratio analysis is one of the most important tools for fundamental analysis as raw numbers do not reveal much.

Financial ratios help compare elements of the financial statements to understand their relationship. They are a diagnostic tool employed to understand the health and performance of a company. Ratio analysis helps in understanding the following:

• Company’s growth
• Meaning and quantity of sustainable profits 
• Use of assets to efficiently generate revenue
• Company’s liquidity position in the short and long terms
• Company’s position to pay back debts and interests timely

Financial ratios have to be compared with previous years' ratios to understand the trends and also with peer companies to understand the status within a peer group. They can be broadly classified as:

• Growth ratios
• Profitability ratios
• Liquidity ratios
• Efficiency ratios
• Solvency ratios

Growth ratios

These financial ratios compare various elements from the financial statements vis-à-vis the previous year or over time.

For example, comparing sales of the current year or past year to find out if sales or revenue has increased or decreased. This is measured in percentage. We can calculate growth for any item of the financial statements to understand its behaviour over the years.

Growth in sales in the below example is calculated as:

Formula: Current Year Sales/Previous Year Sale-1

i.e., ((17397-16350.2)/16350.2) =6.4%.

In the below table, you can see the trend for sales and profits for five years.

The table above shows the company’s revenue or sales growing in double digits from March 2017 to March 2019. However, in March 2020, when the pandemic struck, the growth in sales fell by 6.83%. In March 2021, the company has again come back well, and revenue grew by 6.4%.

Similarly, on the profits front, the company has come back remarkably well post-pandemic, as can be seen from the above table.

Profitability or Margin Ratios

Profitability ratios measure the ability of a company to generate profits from its business activities. A company's profits can be seen at different levels like the gross profit level, operating level, profit before deducting depreciation interest and taxes (PBDIT), profit before interest and tax, profit before tax and profit after tax.

Profitability ratios compare profits at various levels with sales. It measures the percentage of profits the company generates after reducing the various costs at various stages.

Most of the profitability ratios are calculated from the profit and loss account statement. The denominator for calculating the profitability or margin ratios remains the same, that being sales or revenue.

Formula = Various profit/Sales

Profit levels and ratios

Gross margin ratio:

This measures the profit generated by a company after deducting from the sales the cost of goods sold. The cost of goods sold comprises all the direct costs attributable to bringing the goods to saleable form.

Formula: Gross profit/Sales

The company has been maintaining a gross margin in the range of 28% to 33%. After stagnating at a range of 28% to 29%, the company, during March 2021, has improved its margin to a healthy 31.55%.

Operating margin (OPM):

It is one of the more crucial indicators in financial ratio analysis as it measures profits before finance costs, depreciation and amortisation and taxes are deducted. This ratio is referred to by many EBIDTA margins as depreciation and interest are not considered.

EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortisation. OPM measures the operating profit to sales. Operating profit is calculated by deducting the cost of goods sold and other expenses related to selling and distribution and administration expenses from sales. One must note that other income is not part of the above-mentioned ratios.

Formula: Operating profit/Sales

The company has been maintaining a healthy OPM. It has bounced back to over 16% after stagnating at over 11% from March 2018 to March 2020.

EBIT margin:

Earnings Before Interest and Taxes (EBIT) is similar to operating margin, but it is arrived at by deducting depreciation and amortisation.

Formula: EBIT/Sales

A brief analysis:

The company’s EBIT margin improved in March 2021 as compared to March 2020 from 4.9% to 8.52%. It has improved as compared to the past three years.

Net margin:

Net profit or profit after tax (PAT) is the final result of the company's operation. It is the net earnings after deducting all expenses from the total income. Net profit can vary from year to year due to many non-recurring expenses or non-recurring incomes. It is advisable to normalise the data for comparison over some time. Therefore, they should be excluded from all analytical calculations.

Formula: PAT/Sales

The PAT margins improved remarkably well in March 2021 as compared to March 2020. PAT margins bettered the pre-pandemic levels in March 2021.

Shareholder’s return ratios

Return ratios measure the profits attributable to the common shareholders, known as return on equity or return on net worth. It also measures the return attributable to the capital employed in the business. Meaning the return that a company generates on both equity and borrowings that have been applied to the business.

Return on Net Worth (RoE):

Net profit after tax and preference dividends/Average net worth (average total shareholder’s fund)

Average shareholder's fund= (Current year total SH fund + Previous year total SH)/2

A brief analysis:

The return on net worth has come back to pre-pandemic levels, but it is still far away from the March 2017 return of 22%. Further, the company has increased its equity, and there is an addition to the reserves due to the share premium resulting in lower returns.

Return on net capital employed (RoCE):

EBIT/Average Capital employed (average total assets minus average current liabilities).

Here we take EBIT as the profit since capital employed is used.

The return on capital employed improved in March 2021 as compared to March 2020. An increase in total assets has led to a decrease in RoCE. The RoCE is far away from the 22.3% seen in March 2017.

Dupont Analysis

Dupont analysis is nothing but RoE, i.e., return on equity calculated in an elaborate method. Dupont conveys the causes of an increase or decrease in RoE by analysing connected ratios.

There are three important areas of business - profitability, efficiency (use of assets to generate sales) and leverage (external funds to buy assets).

• Profitability is measured by Net profit/Sales
• Asset efficiency by Asset turnover ratio (sales)/Total assets
• Leverage by Total assets/Shareholder’s fund
  The product of these three ratios will give the RoE.

Dupont RoE
= Net margin X asset turnover X financial leverage
= net profit/sales X sales/total assets X total assets/shareholder’s fund

Points to remember:

• Growth ratios can help in comparing various financial aspects from different periods of time to measure growth.
• Profitability ratios help in measuring the company’s ability to generate profits.
• An investor’s return on equity can be measured through Dupont analysis.