Zerodha Varsity · Module 3 · Fundamental Analysis ← Prev: Ch 7–8 · Balance Sheet (Part 2) & Cash Flow
Chapters 9–10. The numbers finally get analyzed. How profitable, how indebted, and how efficient a business really is — and why one ratio alone tells you almost nothing.
You've read the statements; now you make them talk. A single number — "15% profit margin" — sounds meaningful but tells you almost nothing on its own. Is 15% good? Only if you know the competitor does 12%, or that last year this company did 11%. Ratios are the language of comparison, and the most famous of them, RoE, can be honestly high or dangerously inflated depending on how you decompose it.
A financial ratio in isolation is mute — the technique was popularised by Benjamin Graham, the father of fundamental analysis. Ultratech's 15% margin means nothing until you learn ACC's is 12%; then Ultratech is clearly the more profitable of the two. Every ratio needs one of two comparisons: against peers, or against the company's own history. One more caution: accounting policies differ across companies and years, so adjust before comparing.
EBITDA is operating profit — earnings before interest, tax, depreciation and amortization — measuring how efficient the operating model is. Compute it by stripping non-operating items from both sides:
EBITDA = [Total Rev - Other Income] - [Total Exp - Finance - Deprec]
= [3482 - 46] - [2942 - 0.7 - 65]
= 3436 - 2876
= 560
EBITDA Margin = 560 / 3436 = 16.3% (spent 83.7%, kept 16.3% at op. level)Other income is excluded because it comes from investments, not operations — including it would flatter the margin. On its own 16.3% is mute; the 4-year trend (14.6% → 14.4% → 15.2% → 16.3%) shows a rising margin — consistency and improving operational control — with EBITDA growing from ₹257 Cr to ₹560 Cr, a 21% CAGR.
PAT margin is overall profitability after all expenses and tax: PAT ÷ total revenue = 367 ÷ 3482 = 10.5%, also expanding over four years (8.4% → 10.5%), a 25.5% CAGR. Always the same discipline: compare to peers (here, Exide) and to trend.
RoE is the return earned on shareholders' capital — Net Profit ÷ Shareholders' Equity — one of the single most important investable-grade signals. Top Indian companies run 14–16%; the author prefers 18%+. But RoE hides a trap.
Vishal's pizza oven. The oven costs ₹10,000 and earns ₹2,500 profit. Watch RoE climb as he swaps his own money for his father's:
A high RoE can simply mean high debt, not a great business. Vishal's RoE hit 50% with zero improvement in the underlying pizza operation — just more borrowing. High debt inflates RoE while making the company riskier (finance costs balloon). Never admire RoE without checking where it came from.
The DuPont model (1920s) resolves this by decomposing RoE into three telling parts:
Each component earns its place. Net profit margin (9.2%) shows profit-generating ability. Asset turnover (net sales ÷ avg assets = 3437 ÷ 1955 = 1.75x) shows efficiency — ₹1.75 of revenue per ₹1 of assets. Financial leverage (avg assets ÷ avg equity = 1955 ÷ 1211 = 1.61x) shows how much asset base each ₹1 of equity supports — and, crucially, whether the RoE is debt-driven. ARBL's 1.61 is modest (little debt), so its ~25.9% RoE is healthy. A quick RoE (367 ÷ 1211) gives 30.3%.
The "average" technique: because the balance sheet is a flow, a company starts and ends the year with different asset/equity values. So for any ratio mixing a P&L flow with a balance-sheet stock, use (FY13 + FY14) ÷ 2 in the denominator. You'll reuse this in almost every operating ratio.
RoA measures how well assets generate profit, adding back after-tax interest (debtholders are stakeholders too, and interest carries a tax shield): [367.4 + 7×(1−32%)] ÷ 1955 ≈ 19.0%. ROCE measures return on all capital (equity + all debt): EBIT ÷ (short debt + long debt + equity) = 537.7 ÷ 1446.2 ≈ 37.2%.
The RoA and ROCE calculations use a ~32% average tax rate — correct for FY14, but not today. India cut headline corporate tax in 2019 to a ~22% concessional regime (~15% for new manufacturers), before surcharge and cess. The tax shield in RoA is real, but plug in the company's current effective rate, not 32%.
In one breath: a ratio only speaks in comparison; margins show profitability, and RoE — best decomposed via DuPont into margin × efficiency × leverage — is powerful only when you check that its height isn't just borrowed.
Debt is a double-edged sword: used well, it magnifies returns; used badly, its interest bill quietly eats the shareholders' profits until the company can't pay. Leverage ratios measure which edge you're on. Then efficiency ratios ask a different question entirely — not "how much does it make?" but "how hard does every rupee of asset work?"
Because ARBL barely uses debt, the source switches to Jain Irrigation Systems (JISL) — a debt-heavy company — to make these ratios bite.
| Leverage ratio | Formula | JISL FY14 | Reading |
|---|---|---|---|
| Interest Coverage | EBIT / Interest | 1.21x | only 1.21× the interest bill — thin |
| Debt to Equity | Total Debt / Equity | 1.69 | >1 → more debt than equity |
| Debt to Asset | Total Debt / Assets | 45% | 45% of assets funded by debt |
| Financial Leverage | Avg Assets / Avg Equity | 3.68 | ₹3.68 assets per ₹1 equity — high |
Interest Coverage asks how easily earnings cover the interest bill: EBIT ÷ interest, where EBIT = EBITDA − depreciation. For JISL: EBITDA (5828.13 − 5058.15) = 769.98, less depreciation 204.54 = EBIT 565.44; ÷ interest 467.64 = 1.21x. That's dangerously thin — a low coverage means a real risk of default. Debt/Equity (3686.58 ÷ 2175.55 = 1.69) shows more debt than equity. Debt/Asset (3686.58 ÷ 8204.44 = 45%) shows nearly half the assets are creditor-financed. Financial Leverage (8012.6 ÷ 2171.8 = 3.68) confirms a heavily geared balance sheet.
Of the four, interest coverage is the early-warning siren. Debt/Equity can look scary yet be manageable if profits are strong; but a coverage near 1x means almost every rupee of operating profit is going straight to lenders, leaving nothing for a bad year. When coverage drops toward 1, the company is one downturn away from trouble — watch it more closely than the debt level itself.
Operating ratios measure how efficiently assets convert into revenue — also called activity or management ratios. Back to ARBL. Higher turnover = better; any "number of days" = 365 ÷ its turnover.
| Operating ratio | Formula | ARBL FY14 | Meaning |
|---|---|---|---|
| Fixed Asset Turnover | Op. Rev / Avg Net Block | 5.59 | ₹5.59 revenue per ₹1 fixed asset |
| Working Capital Turnover | Rev / Avg Working Cap | 5.11 | ₹5.11 revenue per ₹1 working cap |
| Total Asset Turnover | Op. Rev / Avg Assets | 1.75 | ₹1.75 revenue per ₹1 total asset |
| Inventory Turnover | COGS / Avg Inventory | ~8x | refills stock 8× a year |
| Inventory Days | 365 / Inv. Turnover | 47 | ~47 days stock → cash |
| Receivable Turnover | Rev / Avg Receivables | 8.24x | collects ~8× a year |
| Days Sales Outstanding | 365 / Receivable TO | ~44 | ~44 days invoice → cash |
Working capital = current assets − current liabilities (ARBL's average ₹672.78 Cr); a positive figure means the company can fund daily operations comfortably, negative means it needs a working-capital loan. Inventory turnover uses COGS (materials + stock-in-trade + stores/spares + power/fuel = ₹2449.74 Cr) ÷ avg inventory (₹313.92 Cr) ≈ 8x, so ARBL cycles its stock about once every 1.5 months. DSO (~44 days) and receivable turnover together reveal the credit policy — how long between billing and collection.
A high inventory turnover and low inventory days look like great management — stock flies off the shelf. But the same numbers appear if the company has a hit product and can't produce enough. Before celebrating, ask: is production capped by lack of funds, a bank unwilling to lend (weak management track record?), or hard-to-source regulated raw materials (coal, oil)? If so, the "efficiency" is really a growth ceiling — a red flag. Whenever inventory numbers look impressive, double-check production.
In one breath: leverage ratios (interest coverage most of all) reveal how safely a company carries its debt, while operating ratios expose how hard its assets work — but a dazzling inventory turnover can hide a production bottleneck, so always look behind it.
Because a number like "15% margin" has no reference point. It becomes meaningful only through comparison: against a peer in the same industry (Ultratech's 15% vs ACC's 12%) or against the company's own trend over several years. Always pair a ratio with at least one of those two comparisons before drawing a conclusion.
Because RoE can be inflated by debt rather than by a better business. Vishal's pizza store hit 50% RoE simply by replacing his own equity with borrowed money — the ₹2,500 profit never changed. High leverage magnifies RoE while raising the risk of the finance bill eating profits. The DuPont breakdown shows whether the RoE came from margin and efficiency or from leverage.
The value is in the diagnosis, not the final number. Decomposing RoE into net margin, asset turnover, and financial leverage tells you why the RoE is what it is — strong profitability, efficient asset use, or heavy borrowing. Two companies with identical RoE can have completely different, and differently risky, drivers.
Interest coverage is the early-warning siren. A ratio near 1x means almost all operating profit is going to lenders, leaving no cushion for a bad year. Debt/Equity and Debt/Asset describe the structure, but coverage tells you whether the company can actually service what it owes right now.
Because the balance sheet is a flow: a company begins and ends the year with different asset and equity values. Mixing a full-year P&L flow (like sales) with a single point-in-time balance figure would be inconsistent, so you average the opening and closing balance-sheet values — (FY13 + FY14) ÷ 2.
Not always. Those numbers are excellent if they reflect popular, fast-moving products with ample production. But identical numbers appear when a company simply can't produce enough — a capacity or funding constraint. That's a growth ceiling, not efficiency. Whenever inventory metrics look great, verify the production side before concluding.
A ratio is meaningful only versus peers or the company's own trend — never in isolation.
Four families: profitability, leverage, valuation, operating (loosely bounded, overlapping).
EBITDA margin = operating profitability; PAT margin = overall profitability.
RoE is a top investable signal (prefer 18%+), but can be inflated by debt.
DuPont splits RoE into margin × asset turnover × financial leverage — the quality of the return.
Use average (FY13+FY14)/2 for any balance-sheet figure in a ratio.
Leverage ratios gauge debt safety; interest coverage near 1x is the danger signal.
Operating ratios = efficiency; any "days" = 365 ÷ turnover; verify production behind great inventory numbers.
Part A. DuPont RoE = margin × turnover × leverage. To back out Bazaar's leverage, rearrange: leverage = RoE ÷ (margin × turnover). Higher leverage = more debt-driven = riskier.
Part B. Any "days" = 365 ÷ turnover.
PART A
Kirana RoE = 0.08 x 2.0 x 1.5 = 0.24 = 24%
Bazaar leverage = RoE / (margin x turnover)
= 0.24 / (0.06 x 1.0)
= 0.24 / 0.06 = 4.0x
Same 24% RoE, but Bazaar leans on 4.0x leverage vs
Kirana's 1.5x -> Kirana's RoE is SAFER (less debt-driven).
PART B
Inventory days = 365 / 6 = 60.8 ~ 61 days
DSO = 365 / 10 = 36.5 ~ 37 daysWhy it matters: two identical RoEs can hide very different risk — DuPont is how you tell a well-run business from a heavily-borrowed one.
Reasoning: each collides with a specific point — RoE vs debt, coverage thresholds, the average technique, and the production-capacity trap.
1) ERROR: higher RoE == better business.
FIX: decompose via DuPont. A 40% RoE may be debt-driven
(high financial leverage) and riskier than the peer.
2) ERROR: 1.2x coverage is "fine".
FIX: near 1x means almost all operating profit goes to
interest -> no cushion for a bad year. It's fragile.
3) ERROR: using only closing (point-in-time) assets.
FIX: balance sheet is a flow; use average
(FY13 + FY14)/2 to match the full-year sales flow.
4) ERROR: great inventory numbers = great management, full stop.
FIX: same numbers appear if production is capacity-capped.
Verify the company can actually make enough.Why it matters: ratios are easy to compute and easy to misread — the skill is knowing what each number can hide.