Stray Thoughts on Financial Ratios

Whenever we talk of financial ratios, some students of finance who read only text books come up with weird rules and standards. On Monday I was conducting a viva-voce exam for some students. Most of the summer projects were ratio analysis of the company that they had worked in as interns. First of all ratio analysis is not a two month activity, at best it can be a three hour activity or an overnight assignment on finance, nevertheless these students spent an entire 60 days in companies and then came out with a report on financial ratios. That was the first thing that pout me off. the other thing that put me off was that one of the students confidently came up and said that the current ratio of the company he had worked in was at 1.8 and that it was not ideal. when asked about the ideal ratio he said it should have been 2. I asked him where he has read this, he mentioned the book of one of the finest gurus of finance in India (Dr. I M Pandey). I asked him to bring the book and read the paragraph where Dr. Pandey has categorically written that one should not follow this convention blindly. in fact he has not used the words "rule" or "standard" that goes to show how the students reads and understands according to his convenience.

I asked all these students about their perception of a great blue chip company. They cried ITC and Hindustan Unilever in unison. then i asked them to find out the current ratios of these two companies. being FMCG companies they invariably work on negative net current assets and therefore a negative working capital. That in fact is the reason for their high efficiency. the students went about finding out the current ratios of these companies and came out with the obvious: less than 1. Then the students were convinced that there is no hard and fast rule about the current ratio.

Current ratio (Current assets / Current Liabilities) is calculated to find out the liquidity position of a company or firm when the company or firm is an unknown one. If one is analysing a known brand and a company which is in business for a long time then this becomes redundant. If the company is able to dictate terms to its suppliers and its customers then it will always be in a position to use all the suppliers monies for financing its current assets making use of its own funds redundant. That shows why big companies with bigger brand names are in a position to sell for cash and buy at long credits, skewing their current ratios below unity and therefore operating with negative working capital.

A petty businessman with a lot of commonsense would find this article talking about the obvious. he always know that running a business with others money the right way of running a business.

Now for the opinion on the markets: I reiterate that the markets are poised for a fall. they may pick up some steam and even reach the earlier high of Jan 2008. The distance between today's indices and January 2008 highs is only 10-12%. This distance will be traversed in no time at all and all those investors who realise that the markets have gone up will be the ones who will buy between 5800 and 6250 of the nifty. I pray that more people read this part of the piece and refrain from any buying at these levels. and please do not feel left behind if the nifty actually goes above the 5800, because even if the nifty really touches the previous high it will fall to minimum of 3500 in the coming year 2011. So please reign in your horses. If you still plan to be in the markets then just trade, be nimble, get out at the faintest profit margin. The markets can start falling anytime from now to December and the fall will be substantial.

The NEMESIS of Technical analysts!

Technical analysts in the stock markets and other financial markets rely on past data and charts made out of past data. They find patterns in these charts and follow them to such an extent that they believe that these patterns are gospel truth. Actually these charts are a reflection of the "mass psychology" or the collective mind of the players in the stock markets. There is a proliferation of technical analysts in the markets these days because market men have started to increasingly believe that with the advent of the Internet and the real time television media there is no incentive for any kind of fundamental analysis.

Fundamental analysis is akin to finding value hidden from the average investor. A Fundamental also depends on the past financial data and past experiences with the management of the companies, apart from his / her prognosis about the state of the economy, sector, industry and the company.

Technical analysts tend to forecast the behaviour of the markets depending upon the patterns that these charts make and the levels of the prices. Most technical analysts read the same books and follow the same theories therefore they tend to conclude the same things. The only force that acts against them is the regulatory force like a government or the central bank which can change the course of the markets by setting a new agenda or by directing the economy in a new direction. When ever a market falls to a large extent and there is general despair in the markets, usually the government or one of its arms comes out to support the market. This team that starts working against a trend to stem out the despair is called "The Plunge Protection Team". All the technical analysts who are gloom and doom specialists are wary of this plunge protection team. Some times this team over reacts to the situations and gets into high gear at the fall of a hat. sometimes it takes its own time, not recognising impending dangers and acts too late and in too small measures (that's what happened last year and that's why the markets became bear friendly).

The moral of the story is that, the best type of analysis suited for the markets is something called techno-fundamental analysis which also keeps its eyes open for regulatory changes, world wide happenings and market movements. because in "mass psychology" the government is not part of the "mass". So, i think we can say that the regulator is the nemesis of the technical analyst.

Now for my take on the markets: NIFTY is expected to go forward in its bullish journey up to 3600 and then take a pause for the election results. The results of the General elections will then set the agenda further until then its wait and watch. A short straddle on the NIFTY at 3500 would be ideal for the time being up to April expiry.