Before you can begin investing in stocks/shares, it is important that you learn how to calculate financial ratios to analyse a company If you decide to get your financial ratios from your broker or financial site, you still need to know important financial ratios. Otherwise, you can make a mistake and purchase too much debt into a business, not enough money to survive, or low profitability. Reading the financial reports of a company cannot be exacting work. The annual reports of the company have many pages which consist of a number of financial terms.
If you do not understand what these terms mean, you won’t be able to read the reports.
Nevertheless, there are a number of financial ratios that have made the life of investors very simple to analyse a company. Now, you do not need to make a number of calculations and you can just use these financial ratios to understand the gist.
This guide to financial ratios will explain how to calculate the important financial ratios of a company, and, more importantly, what they mean.
In this article, we are explaining the important financial ratios of a company. We will cover different types of ratios like valuation ratios, profitability ratios, liquidity ratios, efficiency ratios and debt ratios.
Important Financial Ratios to Analyse a Company.
Valuation ratios are one of the important financial ratios for analysing a company. These ratios are used to find whether the stock/share price is undervalued or overvalued. Valuation ratios are generally more helpful in comparing companies in the same sector. For example, these ratios won’t be of that much use if you compare the valuation ratio of a company in the pharma sector with another company in the banking sector. Here are a few of the most important financial ratios to analyse a company.
Price to earnings ratio (P/E ratio)
Price to earnings ratio is one of the most widely used financial ratios by investors in the world.
The P / E ratio represents the cost of each rupee of presently recorded EPS presently being paid by the market. It measures the expectations of investors and the market assessment of a company’s results.
P / E ratio= (market price per share / earnings per share)
The value of PE ratio varies between sector and industry.
For instance, the oil and refinery PE sector is about 10-12.
On the other hand, the PE ratio of FMCG & personal cared is around 55-50. Therefore, you cannot compare the PE of a company from the Oil sector with another company from the FMCG sector. In such a scenario, you will always find oil companies undervalued compared to FMCG companies.
A company with a lower PE ratio is considered undervalued compared to another company in the same sector with a higher PE ratio.
This is a turnover valuation ratio. It is a good valuation tool for companies with lots of debts.
EBITDA = (Market capitalization + debt – Cash)
EBITDA = Earnings before interest tax depreciation amortization
A company with a lower EBITDA value ratio means that the price is reasonable.
PEG ratio: Price/Earnings to growth
PEG stands for the price-to-earnings-to-growth ratio. Price/Earnings to growth ratio is used to find the value of a stock by taking in Consideration Company’s earnings growth.
This ratio is regarded more helpful than the PE ratio, since the PE ratio ignores the growth rate of the company entirely. Using this formula, the PEG ratio can be calculated:
PEG ratio= (PE ratio / Projected annual income growth)
A firm with PEG < 1 is an investment good.
Stocks with a PEG ratio of less than 1 are regarded undervalued in relation to their EPS development rates, while those with more than 1 ratios are deemed overvalued.
The price / sales ratio of the inventory (P / S) measures the price of the inventory of a company against its annual sales.
P / S ratio = (Price per share / Annual sales per share)
P / S ratio can be used to compare businesses in the same sector.Lower P/S ratio means that the company is undervalued.
Dividend Yield is closely related to EPS. While the EPS is based on book value per share, the yield is expressed in terms of the market value per share. The dividend yield is calculated by dividing the cash dividends per share (DPS) by the market value per share, (not price actually paid by investors)
Dividend yield = Dividend per share/Market Price * 100
Companies are not distributing their entire profit to their shareholders. It may keep a some portions of the profit for its expansion or for new plans and share the rest with its stockholders.
Dividend payout tells you the percentage of the profit distributed as dividend.
Dividend payout = (Dividend/ net income)
Profitability ratios are used to measure the efficiency of a company to generate profits from its business. ROA, ROE, EPS, and Profit Margin & ROCE as mentioned below are few of the most significant economic ratios for investors to validate the profitability ratios of the company.
Return on equity (ROE)
Most important profitability metrics is a return on equity. Return on equity tells how much profit a company earned in association to the total amount of shareholder equity found. This is calculated as:
Return on Equity = After tax Net income/Equity
Equity = Equity Share Capital + Reserves and Surplus
A greater ROE implies the business produces a greater profit from the cash invested by the shareholders. Always invest in high ROE businesses.
Return on assets (ROA)
Asset Return (ROA) is an indicator of how lucrative a business is in relation to its total assets. Can be calculated as follows:
ROA = (Net income/ Average total assets)
A company with a higher ROA is better for investment as it means that the company’s management is efficient in using its assets to generate earnings. Always select companies with high ROA to invest.
Increased revenue doesn’t always mean increased profits. Profit margin reveals how good a company is at converting revenue into profits available for shareholders. It can be calculated as:
Profit margin = (Net income/sales)
A business is appropriate for investment with a constant and rising profit margin.
Liquidity ratios are used to check the company’s competency to meet its short-term requirements (like debts, borrowings etc.). A company with low liquidity cannot meet its short-term debts and may face difficulties to run its business efficiently. Here are few of the most important financial ratios for investors to check the company’s liquidity:
It is the most important used ratio to judge liquidity of a company. Current ratio defined as the ratio between current assets and current liabilities.
Current ratio = (Current assets / current liabilities)
Companies with an existing ratio higher than 1 should be preferred while investing. This means that the current assets should be greater than the current liabilities of a company.
Current ratio takes accounts of the assets that can pay the debt for the short term. The quick ratio doesn’t consider inventory as current assets as it assumes that selling inventory will take some time and hence cannot meet the current liabilities.
A company with the quick ratio greater that one means that it can meet its short-term debts and hence quick ratio greater than 1 should be preferred.
Quick ratio = (Current assets – Inventory) / current liabilities
Efficiency ratios are used to study a company’s effectiveness to employ resources invested in its fixed and capital assets. Here are the important financial ratios for investors to check the company’s effectiveness:
Fixed Assets turnover ratio:
This ratio is used to assess the effectiveness of the use of fixed assets.
Fixed Assets Turnover Ratio = Net Sales/Average Net Fixed Assets
Inventory turnover ratio:
It measures how many times an organisation’s inventory has been sold for a year. It is found by:
Inventory Turnover Ratio = Cost of Goods Sold/Inventory
Average collection period:
It is used to check how long a company takes to collect the payment owed by its receivables.
Average collection period = (AR * Days)/ Credit sales
AR = Average amount of accounts receivable
Credit sales= Total amount of net credit sales in the period
Average collection period should be lower as higher ratio means that the company is taking too long to collect the receivables and hence is unfavourable for the operations of the company.
Debt ratios are used to calculate the amount of debt a business has in its present economic position. For investors to verify debt, here are significant economic ratios:
It is used to check how much capital amount is borrowed (debt) vs that of contributed by the shareholders (equity) in a company.
As a thumb rule, invest in companies with debt to equity ratio less than 1 as it means that the debts are less than the equity.
Interest coverage ratio:
It is used to check how well the company can meet its interest payment obligation. Interest coverage ratio can be calculated by:
Interest coverage ratio = (EBIT/ Interest expense)
Where EBIT = Earnings before interest and taxes
If the interest coverage ratio is less than 1, then it’s a sign of trouble as it means that the company has not enough funds to pay its interests.