Company Health

Credits - Balu Gorade

• https://twitter.com/BaluGorade/status/1651608125563375616

Lets understand ROCE, ROE, D/E and few other metrics by a very simple example.

Ramu sells Vadapav.

• He started a biz with 2Lac. Thats equity.

• To grow the business he took loan of 1 Lac. For buying equipment and Land.

• So the total capital in the business is 3 Lac rupees. 

Lets calculate Debt to equity (d/e) of Ramu's business first!

• Debt/equity = Debt/equity.

• Debt/equity = 1L/2L = 0.5

• So in this case, Ramu has 0.5X of debt to his equity. 

Consider, in financial year of 2023 Ramu generated revenue of 5Lac.

• After subtracting raw material cost, employee benefits, marketing cost he made 1.5 Lac.

• So, I.5 Lac is Ebitda (earning before interest, tax, depreciation and amortisation) 

Now lets calculate Ebitda margins.

• Ebitda % = Ebitda/Revenue X 100

• Ebitda % = 1.5L /5L X 100 = 30%

• Ebitda is the core profitability of a business.

• Here in Ramu's case his business generates healthy 30% ebitda margins. 

Then Ramu substracted depreciation and amortisation from the ebitda and left with Ebit of 1.2 Lac.

• Ebit (earning before interest & taxes)

• While calculating ROCE we take ebit as a numerator and total capital as a denominator. 

Now lets calculate the ROCE of Ramus business!

• (Return on capital employed)

• Its one of the most important ratio to measure how efficiently a company using its capital to generate profit.

• ROCE = EBIT/Capital employed X 100.

• In Ramus case his ebit is 1.2 Lac and total capital employed in the business is 3 Lac.

• ROCE = 1.2L/3L X 100 = 40% 

• Ramu generated 40%, on his total capital employed. That's extremely high number. 

Now, lets calculate ROE.

• ( Return on Equity) 

• Equity = Shareholders fund.

• This ratio measures, how efficiently a company generating profits on investors money. 

• To calculate ROE we must know the total income first.

• Consider, Ramu paid 20K of interest and taxes. So his total income is 1 Lac (ebit-tax+interest) 

• So Ramu's net profit for FY23 is 1 Lac. Now calculate ROE!

• ROE = Net income/equity X 100

• ROE = 1 Lac/ 2 Lac X 100 = 50% 

• Ramu generated 50% on shareholders fund. Thats solid number. 

Here we know that Ramus net income is 1 Lac, so we can calculate the profit margins.

• Profit margins = Net income/ Total revenue X 100

• Profit margins = 1/5X100 = 20% 

Interest coverage ratio (ICR)

•  ICR = Ebit/Interest expense

• Consider 10K of interest expense for Ramus business.

• So, ICR = 1.2 L/10K = 12X.

• Ramu has 12X of earning support to cover its interest expense. 

If Ramu lists his business on exchanges, what valuation would you pay to his business? 

• Assume Growth of 20%

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