There are a lot of misconceptions about equity investing. Different people give importance to different information and then there is a mismatch in the expectation. That is how the liquidity comes into the market and people make or lose money.
I am not a great fan of doing detailed ratio analysis for the purpose of investing. I would look more into issues like the promoters, sector, life cycle of the business, etc. In circumstances like this, nothing holds true. The companies and promoters who are the poster boys of the market start losing their shine. Moreover, investors start losing their faith in the market. Hence, is it time to go back to the black board and do number crunching?
What is ratio analysis?
Ratio analysis is a great tool to analyse the companies. Ratios have their limitations and let’s look at the limitations first:
1. Ratios are meaningless in isolation. Ratios don’t provide answers and also have limited value in isolation and need further investigation.
2. Ratios must be compared against:
a. Prior year numbers
b. Competitor’s numbers
c. Budget numbers
3. Ratios are used to analyze trends over different accounting periods which may not be so apparent from the figures.
4. Accounting data can be window dressed.
5. If you are comparing with other companies, you also need to consider the stage in the life cycle of the companies which may distort the ratios.
6. Different industries may use different accounting policies and ratios may not be strictly comparable.
Which ratios shall you consider in the times of crisis?
As you know, risk is always in the balance sheet and hence in the times of crisis, look at the balance sheet. In a market crash and recession, cash and short term assets become paramount for all companies regardless of their size, shape or industry. For example, if the company has more cash than short term debts, it’s a great position to be in. Let’s look at the ratios in brief:
1. Short Term Liabilities: Short Term Assets Vs. Short Term Liabilities. Desirable position: Short Terms Assets should exceed Short Term Liabilities
2. Long Term Liabilities: Short Term Assets Vs. Long Term Liabilities. Desirable position: Short Terms Assets should exceed Liabilities Term Liabilities
3. Debt to Equity Ratio: Desirable level 1:1 but will depend on the industry
4. Is debt reducing or increasing: This should be compared over last 1 to 5 years and against equity. Equity may not grow except by retain earning and if there is a follow up offer but debt can grow considerably depending on the expansion plans of the company and life cycle of the company.
5. Debt Coverage: Is debt – principal and interest repayment- covered by operating cash flow?
6. Interest Coverage: Is there enough operating profit and cash flow to pay interest? Is there company earning interest on any deposits, investments, etc?
If answers to all the above six question are affirmative, the company will do well even in the times of crisis.
Ratio analysis does throw good numbers but one should know how to read those numbers. Otherwise, it’s just another set of data without any information.