Key Financial Ratios to assess IT Stocks

IT companies have been one of the primary drivers of the Indian growth story, especially after the liberalisation of the Indian economy, which reduced the restrictions involved in carrying out business with international parties to a significant extent.

IT companies generally follow the business model of undertaking research and development efforts to bring new technological products and services into the market to assist other industries, engaging in system integrations for other clients, offering solutions consultancy services along with business process outsourcing services.

One of the differentiating characteristics of many IT companies is that they typically have very little to zero inventory levels to fund their business operations. Similarly, the most major cost on their balance sheets is that of employee salaries, and their main assets are intangible, like software and intellectual property.

Let us now go through some key financial ratios which are useful in determining the suitability of an IT company for investments.

Cash ratio

The cash ratio is a stringent measure of whether an IT company is able to satisfy its short-term financial obligations or not. It is computed by summing up the cash and marketable securities held by the IT company, and then dividing this sum by its current liabilities.

Usually, it is preferable that the cash ratio is higher for IT companies, as they commonly have only cash and other liquid securities in order to service their current liabilities.

Current ratio

The current ratio, though similar to the cash ratio, also includes receivables and inventory in the current assets. It can be computed by dividing the current assets owned by the IT company by the current liabilities of the IT company. It gauges how able the company is in satisfying any financial obligations which are short-term in nature. Generally, it is preferred that IT companies have a higher value of the current ratio.

Debt to equity ratio

The debt to equity ratio compares an IT company’s total liabilities to its total shareholder equity, and is computed by dividing the total debt by the total equity. 

It is generally preferred that IT companies have a lower debt to equity ratio, as it is fairly common for companies in this sector to make use of debt-based financing to fund any new product development plans or acquire any competitors to fuel growth. But if this ratio happens to be too high, it places the company in a risky zone as it might become difficult for the company to service such large amounts of debt on their books.

The debt to equity ratio of 5 Indian IT sector companies are:

HCL Technologies: 0.02

Infosys: 0.06

LTI Mindtree: 0

TCS:  0.08

Wipro: 0.16

Source: ICICIdirect. Wipro, LTI MIndtree and HCL Tech nos. are as of March 2022. TCS and Infosys nos. are as of Mar, 2023

Employee attrition rate

Employee attrition refers to the loss of employees from an organization through resignation, retirement, or termination, without any replacement of the vacant positions. Attrition can either be voluntary, where the employees depart of their own volition or involuntary, if the employees are terminated according to downsizing plans initiated by the company.

The attrition rate of a company can be computed by dividing the number of departures by the average number of employees, and then multiplying the result by 100. The average number of employees can be calculated by summing the number of employees at the beginning and the end of a period, and then dividing this sum by two.

The reason why measuring employee attrition levels becomes important is because it might lead to a reduction in the workforce of the company, and the workforce is the primary mode of generating revenue for IT companies. If high performers were to depart from the IT company in significant numbers, the productivity levels and competitive advantages associated with the company might suffer.

A counter perspective says that involuntary attrition, or layoffs, initiated as cost-cutting measures by companies might be perceived positively as employees usually represent the biggest cost on IT companies’ balance sheets.

Operating margin

Operating margin, which is also known as operating profit margin, is a financial measure of a company's profitability.  It is computed by calculating the difference between the revenue earned by the IT company and subtracting all its operating expenses from it, also known as EBIT (Earnings before interest and taxes), and then dividing this difference by the revenue earned, or the net sales generated by the company.

It becomes important to assess the operating margin of companies in the IT sector as it is indicative of the efficiency of the company in being able to convert its revenues into profits, after taking into consideration all the costs incurred while operating the business.

Generally speaking, companies with higher operating margins signal that they are more efficient in controlling their costs and generating profit.

It is also important to note that operating margin can be affected by the tax slab under which the company falls, as this metric only considers the operating income before taxes.

The operating margin of 5 Indian IT sector companies are:

HCL Technologies: 30.88%

Infosys: 26.2%

LTI Mindtree: 17.28%

TCS: 26.71%

Wipro: 18.98%

Source: ICICIdirect, data as of Mar 2023

Resource utilization

Resource utilization rate is a measure which evaluates how efficient an organization is in making use of its resources, such as employees. It is representative of the proportion of resources which are available and that which are actually being used to produce the goods or services.

Typically, high levels of resource utilization rates are indicative of the IT company’s operations running efficiently, whereas low levels of resource utilization rates might point towards underutilization of resources.

Revenue per employee is also an important metric to look into. As per the Business Standard report, the top four IT companies —TCS, Infosys, HCL Technologies, and Wipro — earned a net profit of ₹1.7 lakh per employee during October-December 2022.

Conclusion

One of the most vital things which needs to be done while evaluating an IT company for prospective investments is to view these ratios in unison instead of isolation while also assessing the business and economic environment of the country, in order to obtain a holistic view of the company’s performance.

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