Financial Ratios – Cappuccino or Latte?

Posted on November 21st, 2012 in Financial Modeling - 19 comments

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 ;-))

Financials

(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.

Financials_2

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!

Financial_Particulars

Quick Tip: To quickly convert numbers into percentage in Excel, use the Shortcut: Ctrl + Shift + 5 (Ctrl + %)

Particular_financials_2

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! :-)

Next Steps

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.

Click here to know more about 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 paramdeep@edupristine.com

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Written by paramdeep@gmail.com
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19 Responses to “Financial Ratios – Cappuccino or Latte?”

  1. lockdalf says:

    well, even with the first 4 numbers in the first table I would have said that Cappuccino performs better even without any financial background, just with a bit of common logic. and that is revenue divided by years on the market… 

    That is :

    Cappuccino = 600/2 years is avg. revenue  of 300 pa
    Latte = 800/4 years is avg. revenue of 200 pa

    And since 300 is more than 200…

    ;o]]]

    But still, Latte could have been better if it had smaller investment and larger net profit, which would not be possible to deduce without further data…

    • @lockdalf: Agreed! The information given is not sufficient to deduce a quick result. That is precisely what I am trying to point out. More often than not, we take part information (that is what we have!) and come to conclusions, which can be dangerous.

      As @Meiryo points out, we can’t use average revenue as a measure to compare two firms. Revenue is a yearly measure and hence one shall compare firm’s respective yearly numbers.

      Let’s have another scenario where both companies are established in same year i.e. FY 2010 and revenue figures are same as mentioned in above article.

      Cappucino- USD 600 Mn

      Latte- USD 800 Mn

      Can we definitely say ‘Latte’ is performing better? ;)  We can’t say it for sure…

      To be sure about performance, we have to ask for additional information such as equity invested by each firm, Net income for both firms, etc. So, the point is one can’t decide the firms performance solely on revenue numbers (and sometimes we just do that!)

  2. [...] the original here: Introduction to Financial Ratios & Calculating them using MS Excel … ← Recognizing a Header Row When Sorting – Microsoft Excel Tips [...]

  3. Rahim says:

    Awesome information… Thanks for sharing and Keep Sharing

  4. Rahim says:

    Please share more information and postings related to Financial modeling and Finance for Non Professionals. Thanks
    Great Work

  5. Paulo says:

    Purna, you rock!
    Your blog is awesome.
    I just learned a few tricks and incorporated in plain spreadsheet.
    http://i48.tinypic.com/246jnth.jpg 

  6. Bob says:

    How about cash flow?  It is certainly possible to have positive income and negative cash flow.  If Cap’s cash flow is negative, or even less than net income I would be suspicious.  Also, Cap’s equity could be lower than Lat’s because Cap has more debt.  No analysis is complete without looking at the details of the balalnce sheet and the cash flow statement.

    • @Bob: Importance of Cash flows and capital structures is definitely to be considered while comparing performance of two different firms. This article is a starting point for a guy who doesn’t have any finance background and hence I have not considered cash flows and capital structure details.

      I would be sharing more information through articles on the same and we are planning to release a course with video instructions on the same.

  7. Meiryo says:

    If the question is “which company is better?” (which is different from “which company performed better in 20XX), then I would argue that there still is unsufficient data above. While it is important to look at “snapshot” ratio the way you suggest, we would never do it without the context of a trend.
    Prima faciae, Capucino seems to be perfoming better than Latte (at least from a shareholder’s perspective(*)). But simply knowing than in 2012 the former’s ROE is higher than the latter’s does not tell me that Capucino’s is not on a downward trend while Latte’s is, maybe, growing.
    Assuming that would be the case, then maybe a closer look at fundammentals (as obviously a past trend in itself is no indication of future performance, and in any case ratios should always and just be invitation to dig in the down-to-earth detail of the business)  would suggest the trend is here to stay and that it is reasonnable to expect that in the next few years Capucino will get down to the single digit while Latte will slowly but steadily reach the stars…
    As you said, things should be viewed in a holistic manner, but a video is usually better than a still snapshot. An in that exercise, excel has plenty of possibilities to offer for relevant comparisons…so I’m pretty excited to see you starting to tackling this interesting topic !
    All the best.
     
    (*) ROE may not be the most relevant indicator for other stakeholders, such a debt-provider, a commercial counterpart assessing performance/payment risk, etc…
     

  8. Meiryo says:

    @ lockdalf,  “Revenue” and “Net Income” are actually periodic measures, usually yearly. Hence you can’t divide them by years in the market. There is a measure that is accumulative, namely “accumulated earnings”, which sometimes bears alternative names, and that can be found in the net asset (equity) part of the balance sheet (whereas revenue and net income are in the statement of income, or “profit and loss statement”).But even in that case, the method would in fact be very debatable because retained earnings are also function of dividend policies and of a couple other funny accounting ways of seeing life, but that’s of course pushing the discussion beyond what is intended in the article.
    By the way, “revenue” a.k.a the top line should by no mean be considered to be the benchmark to gauge a company’s performance. If your revenue doubles each year but your costs triple at the same time, then as you would appreciate, you will soon be in the red. Net income would be a better indication, although it must be looked at not only quantitatively but also qualitatively (e.g. a great bottom line that was derived through an exceptionnal gain on asset disposal, for instance, or FX gain, is not an indication that the company is intrinsically sound and able to generate value over the long term. With the same net income figure, a company with a rather stable revenue and predictible revenue stream linked to the “normal” activities, with cost well under check, is more likely to be performing as well the next year.).


    • @Meiryo: Agreed with your comment. Thanks for sharing and answering!

    • lockdalf says:

      @Meiryo, I have to say you lost me there…. as I mentioned, I have no financial background. Even my job has nothing to do with finances (at least not directly) + English is not my first language, so some of the terms are gibberish to me (not that I would understand them better in Slovak… ;0]]] ) so s

      I was just pointing that even based on the first initial data it was possible to make the same conclusion as with the additional supplied data. It clearly shows that there are so many angles to cover, that it is very difficult to compare what is better (and not just with companies performance), as it always depends on the viewers criteria of importance….

      But I have to fully agree wit you and the other statements above… without a clear trend shown, the decision making can be a killer…

  9. zur says:

    GREAT START

  10. ShoppingMonk says:

    thanks for the tips. I am leaning a tip everyday using your blog and practicing it :)

  11. [...] Also you can download this filled template and check, if the information you recorded, matches mine or not! …More at Financial Ratios – Cappuccino or Latte? – Chandoo [...]

  12. RahulG says:

    Every Good blog. Thank you making me learn excel :)

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