Fundamental Analysis in Stock Market: Evaluating Profitability, Liquidity, Leverage, and Efficiency Ratios

Fundamental analysis in the stock market evaluates a company's intrinsic value by examining its financial statements, management, industry position, and economic factors. It analyzes key financial indicators like revenue, earnings, assets, liabilities, and cash flow.

Key Components:

1. Financial Statements: Investors analyze a company’s income, balance, and cash flow statements.
2. Income Statement: Shows profitability, revenue, expenses, and net income.
3. Balance Sheet: Provides details about a company’s assets, liabilities, and shareholder equity.
4. Cash Flow Statement: Shows how a company generates cash to fund its operations, investments, and financial obligations.
5. Management and Business Model: Investors evaluate the company’s leadership, competitive advantages, and how it operates within its industry.
6. Macroeconomic Factors: External factors like interest rates, inflation, and industry conditions can affect a company’s growth and profitability.

Key Financial Ratios in Fundamental Analysis

1. Profitability Ratios: Profitability ratios are a set of financial metrics that measure a company's ability to generate profit relative to its revenue, assets, or equity. Key profitability ratios include:

• Gross Profit Margin: Indicates the percentage of revenue that exceeds the cost of goods sold (COGS), reflecting production efficiency.
• Net Profit Margin: Measures the percentage of profit generated from total revenue, indicating overall profitability after all expenses.
• Return on Assets (ROA): Assesses how effectively a company uses its assets to generate profit, highlighting asset efficiency.
• Return on Equity (ROE): Evaluates how efficiently a company generates profit from shareholders' equity, reflecting shareholder returns.
• Return on Capital Employed (ROCE): Measures how effectively a company uses its capital to generate profits, indicating capital efficiency.

a) Gross Profit Margin:

Indicates the percentage of revenue left after subtracting the cost of goods sold (COGS).

Formula: (Revenue - COGS) / Revenue

Example:

Maruti Suzuki:

Revenue = ₹1,24,600 crore

COGS = ₹93,000 crore

Gross Profit = ₹1,24,600 - ₹93,000 = ₹31,600 crore

Gross Profit Margin = (₹31,600 / ₹1,24,600) × 100 = 25.36%

Tech Mahindra:

Revenue = ₹58,229 crore

COGS = ₹44,520 crore

Gross Profit = ₹58,229 - ₹44,520 = ₹13,709 crore

Gross Profit Margin = (₹13,709 / ₹58,229) × 100 = 23.51%

Comparison: Maruti Suzuki had a higher gross profit margin, indicating better control over production costs than Tech Mahindra.

 

b) Return on Equity (ROE):

Assesses how efficiently a company is generating profit from shareholders' equity.

Formula: Net Income / Shareholders’ Equity

Example:
Axis Bank:

Net Income = ₹21,933 crore

Shareholders' Equity = ₹1,21,444 crore

ROE = (₹21,933 / ₹1,21,444) × 100 = 18.07%

Bajaj Finserv:

Net Income = ₹6,883 crore

Shareholders' Equity = ₹23,315 crore

ROE = (₹6,883 / ₹23,315) × 100 = 29.52%

Comparison: Bajaj Finserv had a higher ROE, meaning it generated more profit per unit of equity than Axis Bank.

 

c) Net Profit Margin:

Measures the percentage of profit generated from revenue.

Formula: (Net Income / Revenue) × 100

Example:

Infosys:

Net Income = ₹19,351 crore

Revenue = ₹1,14,236 crore

= (19,351/1,14,236)×100=16.95% 

Wipro:

Net Income = ₹10,491 crore

Revenue = ₹64,649 crore

= (10,491/64,649)×100=16.24%

Comparison: Infosys had a higher net profit margin, indicating it retained more profit from each unit of revenue generated compared to Wipro.

d) Return on Capital Employed (ROCE)

ROCE is a profitability ratio and also considered an efficiency ratio. It measures how efficiently a company is using its capital to generate profits. ROCE is particularly useful for assessing the profitability of companies with significant capital investments, as it indicates how well the company is using both its debt and equity to generate returns.

Formula: ROCE = Earnings Before Interest and Taxes (EBIT) / Capital Employed

Capital Employed is calculated as Total Assets - Current Liabilities, or alternatively, as Shareholders' Equity + Long-term Debt.

Example:

Hindustan Unilever:

EBIT = ₹9,500 crore

Capital Employed = ₹50,000 crore

ROCE = (9,500/50,000)×100=19.00%

ITC Limited:

EBIT = ₹14,500 crore

Capital Employed = ₹70,000 crore

ROCE = (14,500/70,000)×100=20.71%

Comparison: ITC Limited had a higher ROCE, indicating it was more effective at generating profits from its capital compared to Hindustan Unilever.

 

2. Liquidity Ratios:  Liquidity ratios are financial metrics that assess a company's ability to meet its short-term obligations using its current assets.

Key Ratios:

• Current Ratio
• Quick Ratio (Acid-Test Ratio)

a) Current Ratio:

Evaluates a company's ability to meet short-term obligations using its current assets.

Formula: Current Assets / Current Liabilities

Current Ratio:

Formula:

Current Assets / Current Liabilities

Apollo Hospitals:

Current Assets = ₹5,210 crore

Current Liabilities = ₹4,230 crore

Current Ratio = ₹5,210 / ₹4,230 = 1.23

HCL Technologies:

Current Assets = ₹35,224 crore

Current Liabilities = ₹15,000 crore

Current Ratio = ₹35,224 / ₹15,000 = 2.35

Comparison: HCL Technologies has a better liquidity position, able to cover its liabilities more comfortably than Apollo Hospitals.

 

b) Quick Ratio (Acid-Test Ratio):

A stricter measure of liquidity that excludes inventory from current assets.

Formula: (Current Assets - Inventory) / Current Liabilities

Quick Ratio:
Formula: (Current Assets - Inventory) / Current Liabilities
Bharti Airtel:

Current Assets = ₹17,546 crore

Inventory = ₹1,250 crore

Current Liabilities = ₹18,384 crore

Quick Ratio = (₹17,546 - ₹1,250) / ₹18,384 = 0.90

Maruti Suzuki:

Current Assets = ₹27,155 crore

Inventory = ₹5,438 crore

Current Liabilities = ₹12,279 crore

Quick Ratio = (₹27,155 - ₹5,438) / ₹12,279 = 1.77

Comparison: Maruti Suzuki has better quick liquidity, relying less on inventory to meet short-term obligations compared to Bharti Airtel.

3. Leverage Ratios: Leverage ratios are financial metrics that measure the extent to which a company uses debt to finance its operations and investments, indicating the level of financial risk.

Key Ratios:

• Debt-to-Equity Ratio
• Interest Coverage Ratio

• a) Debt-to-Equity (D/E) Ratio:

Measures a company’s financial leverage by comparing total debt to equity.

Formula: Total Liabilities / Shareholders’ Equity

Formula:

Total Liabilities / Shareholders' Equity

Bajaj Finserv:

Total Liabilities = ₹1,07,046 crore

Shareholders' Equity = ₹23,315 crore

D/E Ratio = ₹1,07,046 / ₹23,315 = 4.59

Axis Bank:

Total Liabilities = ₹2,74,290 crore

Shareholders' Equity = ₹1,21,444 crore

D/E Ratio = ₹2,74,290 / ₹1,21,444 = 2.26

Comparison: Bajaj Finserv has higher financial leverage than Axis Bank, relying more on debt financing.

 

b) Interest Coverage Ratio:

Indicates a company’s ability to pay interest on its debt using its earnings.

Formula: Earnings Before Interest and Taxes (EBIT) / Interest Expenses

Interest Coverage Ratio = ₹8,682 / ₹524 = 16.56

Tech Mahindra:

EBIT = ₹5,682 crore

Interest Expense = ₹204 crore

Interest Coverage Ratio = ₹5,682 / ₹204 = 27.86

Comparison: Tech Mahindra has better interest coverage, indicating a greater ability to meet its interest obligations compared to Maruti Suzuki.

 

4. Efficiency Ratios: Efficiency ratios are financial metrics that evaluate how effectively a company utilizes its assets and manages its operations to generate revenue and maximize profit.

Key Ratios:

• Asset Turnover Ratio:  Shows how efficiently a company uses its assets to generate revenue.

Formula: Revenue / Average Total Assets

Example:
Maruti Suzuki:

Revenue = ₹1,24,600 crore

Average Total Assets = ₹1,51,200 crore

Asset Turnover Ratio = ₹1,24,600 / ₹1,51,200 = 0.82

HCL Technologies:

Revenue = ₹88,587 crore

Average Total Assets = ₹1,32,281 crore

Asset Turnover Ratio = ₹88,587 / ₹1,32,281 = 0.67

Comparison: Maruti Suzuki used its assets more efficiently to generate revenue than HCL Technologies.