Learn about Financial Ratios

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Financial ratios are created with the use of numerical which are taken from financial statements to gain meaningful information about a company. It might not be possible for every investor to meet a company’s management or do an in-depth study of their financials. In such situations, financial ratios are key to understanding the health of the company at a quick glance. As it provides beneficial information about the company such as balance sheets, cash flow and income statements etc. Financial ratios are the perfect tool for investors to measure the health of a company.

Importance of Financial Ratios

It is essential for investors to understand key financial ratios, their meaning and impact on the stocks. Financial Ratios help:
• Investors in deciding whether to invest in a company or not.
• Investors track the company’s performance and can help early identification of trends.
• Investors compare the performance of the company against its competitors and industry as a whole.

Types of Financial Ratios

Financial Ratios are divided into various types based on the information that they provide. The key types of financial ratios are:
1. Profitability Ratios: Helps measure company’s ability to generate profits/income
2. Return Ratios: Helps measure company’s efficiency in managing the investments
3. Leverage Ratios: Helps measure company’s debt
4. Liquidity Ratios: Helps understand company’s ability to repay short-term and long-term loans.
5. Valuation Ratios: Helps evaluate the share price of a company.

Profitability Ratios

Profitability ratios define how profitable the operations of the company are on per rupee of sales basis.

EBITDA Margin: This ratio is useful in finding out the profitability of the company purely based upon its operations and direct costs.

EBITDA Margin = EBITDA / Net Sales

A company with a higher EBITDA margin, indicates that it is able to operate with greater efficiency. EBITDA margins are useful in identifying profitability trends in an industry since it is not affected by the depreciation policies, funding decisions and taxation rates of the companies.

PAT Margin: Shareholders of a business get their dues only at the end, i.e. after paying all stakeholders, including the government. Hence, they would like to know how much of the business generated by the company actually comes their way. This is found by calculating PAT Margin.

PAT Margin = PAT/ Net Sales

A company with a higher ratio is seen as more efficient in managing costs and earning profits. A trend of increasing margins means improving profitability.

Return Ratios

While Profitability ratios give a sense of profitability per rupee of sales by the business, they do not communicate anything on the productivity of each rupee invested in the business. This part of allocation of capital and its productivity is captured through comparing profits with the capital employed in the business.

Return on Equity (ROE): This is the single most important parameter for an investor to start digging for more information about a company. ROE communicates how a business allocates its capital and generates return. An efficient allocator of capital would have high ROE and a poor quality of business would have low ROE. ROE, sometimes also known as Return on Net-worth (RoNW).

ROE = PAT/Net-Worth
Net-Worth = Equity Capital + Reserves & Surplus

Return on Capital Employed (ROCE): This ratio uses EBIT and calculates it as a percentage of the money employed in the firm by way of both equity and debt.

ROCE = EBIT/ Capital Employed
Capital Employed = (Total Assets – Current Liabilities) or (Total Equity + Total Debt)

Higher the ratio, better the firm since it is generating higher returns for every rupee of capital employed. Investors can use this to analyse the returns of companies with different sizes in the same industry.

Leverage Ratios

Leverage ratios show how much capital comes from debt or assesses ability of the company to meet its long term financial obligations.

Debt to Equity Ratios: Debt to Equity ratio shows the total debt of a company against shareholder’s equity. A high debt to equity ratio is not a favourable sign for equity investors as it signifies high risk.

Debt to Equity Ratio = Total Liabilities / Shareholder’s Equity

Interest Coverage Ratio: This financial ratio signifies a company’s ability to pay its interest obligations. High interest coverage ratio means that the company can make timely interest payments and is a good sign for debt investors.

Interest Coverage Ratios = EBIT/Interest Expenses

Liquidity Ratios

Liquidity ratios such as current ratio, acid-test ratio etc helps investors understand if the company has enough assets to repay its short-term and long-term loans.

Current Ratio: Current ratio measures the company’s ability to repay short term loans with existing assets.

Current Ratio = Current Assets / Current Liabilities

A high current ratio means that the company has sufficient cash to meet short term liabilities and is financially strong. Whereas, a low current ratio reflects poor financial health and may also indicate default.

Quick Ratio: Quick ratio is also known as Acid-test ratio and evaluates a company’s ability to repay its short term liabilities with its quick assets.

Quick Ratio/Acid-test Ratio = Current assets – Inventories / Current Liabilities

Operating Cash Ratio: This financial ratio highlights the number of times a company can pay off its liabilities from generated revenue.

Operating cash Ratio = Operating cash flow / Current Liabilities

Cash Ratio: Cash ratio evaluates a company’s ability to repay its short-term liabilities with ONLY cash and cash equivalents.

Cash Ratio = Cash & Cash Equivalents / Current Liabilities

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Valuation Ratios

Ratios such as Price to Earnings, Price to Sales, Price to Book Value, Earnings Yield, Dividend Yield, Enterprise Value to EBIT(DA) Ratio and Enterprise Value (EV) to Sales Ratio provides insights for investors about company’s valuation.

Price to Earnings Ratio (P/E): PE Ratio measures the price that the market is willing to pay for the earnings of a company.

P/E Ratio = Market price per share/Earnings per share

Price to Sales Ratio (P/S): Price to Sales ratio is a valuation ratio that measures the price investors are willing to pay for each rupee of sales.

P/S Ratio = Current Market Price (CMP) / Annual Net Sales per Share

OR

P/S Ratio = Market capitalization / Annual Net Sales

Price to Book Value (P/BV): Price to Book Value Ratio is one of the most widely used ratio to find price relative to the value. The P/BV measures a company's current market price (CMP) vis a vis its book value. Book value is calculated by dividing net-worth by the number of outstanding shares.

Dividend Yield – Price to Dividend Ratio: Dividends are the profits that the company pays out to its equity holders. Well managed companies maintain a stable dividend payout to its investors even while ensuring that the growth prospects of the company are adequately funded, by ploughing back a portion of the profits. Dividends can be compared with the share price for a sense on cheapness or expensiveness of equities.

Dividend Yield = Dividend per share (DPS) / Current price of stock

Earning Yield - Price to Earnings Ratio: When dividend yields are quite low, market analysts move to earning yields, a step higher to consider the investment potential in a stock.

Earning Yield = Earnings Per Share (EPS) / Current price of stock

The reciprocal of Earning Yield is the popularly known Price to Earnings Ratio.

Growth Adjusted Price to Earnings Ratio (PEG Ratio): Companies with high (low) growth rate would trade at a premium (discount) compared to their peers. However, determining the amount of premium is likely to be subjective. Growth adjusted price to earnings ratio (also called PEG Ratio) overcomes this problem by factoring in growth rate in its calculations.

Growth adjusted Price to Earnings Ratio = [Current Price of Stock / Earnings Per Share] / Growth rate

Enterprise Value to EBIT(DA) Ratio: EPS and in turn ratios such as PE or PEG ratio, are impacted by the capital structure of the business. When a company is valued from the perspective of an acquirer or when it is a potential acquisition target, it would be more appropriate to value it based on Enterprise value/EBIT or Enterprise Value/EBITDA ratios.

Enterprise Value (EV) to Sales Ratio: PE ratio, EV/EBITDA or EV/EBIT ratio cannot be applied if the underlying profit metric is negative (i.e. loss). EV/Sales is likely to be a more meaningful metric as sales can never be negative

Hope this article helps readers who looks for a quick glance on the mostly used financial ratios.