Financial Ratios – Cappuccino or Latte?
This is a guest article by Paramdeep, a financial modeling expert & teacher.
A Quick Question for you!
Don the hat of a financial wiz today. What I have for you are the financials of two companies: Cappuccino and Latte – Two dot com companies (Sometimes they also make revenues ;-))
(Remember, when they make money, they make it fast!)
Which is better – Cappuccino or Latte? ( Hint: It’s a trick question! 😉 )
It may seem obvious that Latte is performing better (Higher the revenue, the better the performance!). Sometimes a single source of data does not speak the full story!
What the data does not speak about?
Absolute values of Net Income or Revenue can give confusing signals. Absolute numbers can vary based on Size of Firm in terms of Invested Capital, Sales, Net Income, etc. The data needs to be looked at, in a holistic manner. For example, Ratios get you the common sized numbers (That’s a jargon for saying that for USD 1 of denominator, what is the numerator that I make).
What can reveal the Story?
We can use Ratio Analysis tool to make you a better Whiz at finance. So what ratios could be useful and what do they imply?
Net Profit Margin (NPM)
- How to Calculate: Net Income/ Revenue
- What does it measure: Net Profit Margin measures how much out of every dollar of Sales a company actually keeps in earnings
What other Ratios can be useful?
Return on Equity
- How to Calculate: Net Income/ Equity Invested
- What does it measure: Return on Equity measures the efficiency with which stockholder’s investment has been used.
More Information Required to Assess the Performance
Let’s say I had given you more information (Now don’t complain – If you had asked for it earlier, I would have happily given it to you!)
Now, check Net income and Equity investment of both these companies given in table below.
Calculating in Excel
Simple. All you need to do is divide the Net Income by revenue and divide the Net Income by Equity investment. Excel makes the calculations a breeze!
Quick Tip: To quickly convert numbers into percentage in Excel, use the Shortcut: Ctrl + Shift + 5 (Ctrl + %)
And bang! You get the correct formatting!
Quick Word on Analysis
Net profit margin for Cappuccino is 15% and for Latte it is 11%. It means for every USD 1 of Sales, Cappuccino makes 15 Cents as earnings, whereas Latte gets only 11 Cents. That means tomorrow if the revenue of Cappuccino and Latte increase by the same dollar amount, Cappuccino would outperform Latte!
Company with high profit margin with high investment may not be returning a great amount to investors. Firm with low profit margin may have required a very small investment so that it proves highly profitable to those who invest in it.
To assess the return to the shareholders, we can look at Return on Equity (RoE) ratio. RoE for Cappuccino is 18% and for Latte it is 13%. It indicates that for every USD 1 of equity invested, Cappuccino shareholder’s gets 18 cents, whereas Latte shareholder’s gets only 13 cents.
If you would have had complete information, you could have said Cappuccino is better!
Templates to download
I have created a template for you, where the subheadings are given and you have to link the model to get the cash numbers! You can download the same from here. You can go through the case and fill in the yellow boxes. I also recommend that you try to create this structure on your own (so that you get a hang of what information is to be recorded).
Also you can download this filled template and check, if the information you recorded, matches mine or not!
This series gives you a flavor of some basics concepts on finance that are very important for professionals engaged in non-finance activities as well. To learn more about various financial concepts & how to do financial analysis using Excel, consider joining our Finance for non-finance people course.
For any queries regarding the cash impact or financial modelling, feel free to put the comments in the blog or write an email to firstname.lastname@example.org
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