Updated: Sep 29, 2019
Why are Financial Ratios important?
Imagine you have to take multiple decisions to invest in a basket of stocks within a short span of time, you have loads of financial statement information to go through like balance sheet, profit and loss statement, cash flows etc . Now this can’t be done within a day, it would require days of reading and analysis, this is where financial ratios come to rescue.
Ratios can be very helpful in identifying and determining where a company’s position is standing. Ratios can also help in comparing the financial position of the stock in which we want to invest in with that of the industry or similar line of companies.
Valuation of investment is a complex process and only technical experts or valuation experts can understand that process, calculating quick and simple financial ratios of a company can act as saviour for people like us. Financial ratios can be used to perform quantitative analysis of the company and also assessing the companies growth potential, liquidity, leverage, efficiency and profitability.
If you have good command and understanding of the calculation of financial ratios, it would be a cake walk to analyse and perform the sound worthiness of a company for the purpose of investment.
Types of Financial Ratios which can be used for Stock Analysis
Price/Equity Ratio - The PE ratio determines how much a stock investor is willing to pay
for each rupee of earning. Some people confuse P/E ratio with means of determining the valuation of company, P/E ratio is simply (Earning per share*/total number of shares). P/E ratio is generally determined for companies that are earning profits. Almost all listed companies on BSE or NSE has a PE ratio. PE ratio can be extensively used to see if the company is undervalued or overvalued. For example if a company's PE ratio is 15 and the industry average PE ratio for similar companies is 20, that means the company is undervalued, but if the PE ratio of the company is 22, then in terms of industry average, the company is overvalued. Generally investors invest in a stock if it is undervalued (i.e the P/E ratio is lower in terms of industry standards) because for such kind of stock the market is paying less right now in terms of its actual earning per share, and has potential to pay as per the actual earning per share of that company leading to rise in price. Refer for more details here
*Earning per share - EPS is generally derived by dividing the company's net profit by total number of outstanding shares.
Price earning to growth ratio - The price earning to growth ratio (PEG ratio) is a stock's price to earning ratio (P/E) divided by the growth rate of its earnings over a specified time period.
One thing to consider in PEG ratio is that we are estimating the growth factor over here which means different sources of that ratio for the same company may show different numbers, since growth is just an estimate and not the actual number which is based on historic data of the company. According to well-known investor Peter Lynch, a company's P/E and expected growth should be equal, which denotes a fairly valued company and supports a PEG ratio of 1.0. When a company's PEG exceeds 1.0, it's considered overvalued while a stock with a PEG of less than 1.0 is considered undervalued.
Current Ratio - While choosing a stock, Investors should always assess the cash worthiness of a company, this is where Current ratio comes into picture. Current Ratio (Current Assets/Current liabilities), ideally should not be less than 1) is nothing but the amount of short term assets or cash a company has to satisfy its short term obligations and liabilities. It can also be one of the major factors to assess a company's going concern. Whether the company has sufficient cash to pay off its short term dues or not.Generally you should not only look at current ratio while making a decision to invest in a stock, but it can definitely be used in conjunction with other ratios for e.g debt equity ratio (talked below) to assess the overall operating capability of a business.
Debt/Equity Ratio - This is one of the most important ratio when assessing the credit worthiness of a company, this ratio shows how the company is leveraged (i.e how much debt (outside liability) a company has against the owners equity (includes promoters and stakeholders). If a company has a higher debt does not necessarily mean the company is at risk, higher debt can also be leveraged beneficially if the returns on equity are higher, but in case the returns on equity are less, then in that scenario the company can have a negative impact due to higher debt since the interest burden on debt will be higher than the return on equity and owners stake might be at risk in that scenario. Some capital extensive companies like the ones in automobile and manufacturing segments where the expenditure on equipment and machinery is higher, the debt equity ratio can change overtime, since the company will take outside debt for acquiring assets, and once the assets start churning production from which the company will start earning profits and repaying debts, the debt equity ratio will be generally higher in the beginning and lower in the lateral stages. In such situations we should look at the long term recover ability of the company and not only analyse the debt/equity ratio as on the present date.
Operating profit margin ratio - Operating profit margin is generally used to assess the operating effectiveness of a company. Operating profit margin (OPM) (Operating profit/Net Sales), is used to assess how much revenue a company is generating after meeting all expenses like raw material costs and other variable costs. This ratio is necessary to understand the growth of a company, a company with increasing operating profit margin (YOY) represents a healthy business, we can also compare operating profit margin with similar industries to see the performance and durability of a business.
Market to book ratio - Book value represents the net asset value of a company (Tangible assets such as property and machinery minus depreciation and other outside liabilities), Market value on the other hand is the( market price x number of outstanding shares) of the company. Price to book ratio is (Market value/book value). Generally market value of the company will always be higher than the book value since market value is driven by market sentiments and also considers the future growth potential of a company (i.e increasing capacity, expansion plans, diversification of business) whereas book value is based on historical cost of tangible assets and does not take into consideration the future benefits. Market to book ratio (also known as price to book P/B ratio) is generally used in conjunction with return on equity (explained below) .
Return on capital employed/Equity - Return on capital employed (ROCE) is a financial ratio that measures a company's profitability and the efficiency with which its capital is used. ROCE is (Earning before interest and taxes/Capital employed), (capital employed = Total assets - outside liabilities) in other words, the ratio measures how well a company is generating profits from its capital. The ROCE ratio is considered an important profitability ratio and is used often by investors when screening for suitable investment options. A company can have a higher revenue and sales but a lower return on capital employed which means the company is not employing its capital effectively and is not enhancing shareholder value.
Dividend yield - Dividend ratio (Annualised dividend/current stock price) is generally calculated for companies which are mature and stable in market and render dividend yield to its investors year over year. The dividend yield ratio assumes that the company in question will continue making dividend payments at the same or higher rate than it is currently doing. A historical analysis of the stock market will validate this assumption. Historically companies that have been making dividend payments continue to do so. This is because a dividend cut is adversely received by the market as a very negative signal and the share price immediately plummets. It is therefore reasonable to assume that the company will continue to pay dividends until something untoward happens.
Interest Coverage Ratio (ICR) - This is an indicator of whether the company has sufficient funds to service its debt charges (i.e majorly interest on debt), this ratio is calculated as ratio of (Earning before interest and taxes/Interest expenses), that is ratio of operating profit to interest outgo. A company with an ICR of 2 generally implies that it can service more than twice its current interest charges, whereas a company with an ICR of 0.5 implies that it can service half of its current interest charges.
Generally financial ratio information is readily available to investors from Broker websites or company's website , but to analyse and combine different ratios for the purpose of making investment decisions is an art, and it can only be developed overtime once you start reading and understanding balance sheet and other related Annexure statements and schedules.The significance of ratios can be huge , finding a company with perfect leverage (Debt to equity ratio) and consistent profitability (consistent increase in Return on capital employed YOY) combining that with a good P/E ratio (not too overvalued and not too undervalued) can be an ideal scenario to invest in a stock for long term. Depending upon your investment style (Conservative or aggressive) (for more details on type of investors click here) you can perform your analysis. Ratios generally should not be used alone for stock analysis but lot of other factors such as market factors, company's growth plans, macro economic factors surrounding company's line of business (For more details click here ) should be considered.
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