Financial Ratios may be considered as one of the major tools in the stock market. They are used to analyze potential investments. Everyone from beginners to absolute experts should use financial ratios to analyze stocks of their interest. But, what are financial ratios? How to analyze them? Shall some be given preference? What are ideal financial ratios? Here are your answers.
What are Financial Ratios?
Ratios are mainly used to compare two quantities that are related to each other. Let’s play a game. Suppose there are two companies, company A and company B. Further, company A earns ₹500 while company B earns ₹5,000. Where would you like to invest? company B. right?
Keep that in mind while I move forward. What if I say company A requires ₹10,000 to earn that ₹500, whereas company B requires ₹1,20,000 to earn its ₹5,000. What would be your answer now?
By following the pattern company A has 5 % returns on money, whereas company B has a return of about 4.16 %. So, company A suddenly becomes a better opportunity than company B. interesting, isn’t it? How can just a fact change the entire thought of the investor?
Why financial Ratios are Important?
Imagine that company A has 500 shares and company B has 4000 shares. Now that thoughts shift again, company A has an EPS (Earning per Share) of ₹1.00(₹500 /500 shares) whereas company B’s EPS is ₹1.25 (₹5,000/4,000 shares). Again the Swings start to rotate and company B gains an upper hand.
Further, total assets of A amount to ₹2,500 whereas B employs Assets of ₹35,000. By this time you are alert to any illusions and would like to have further information. At last the games over, the only one to win is you. As you are now learning to notice not only one factor at a time but looking at more of them. At any period doing Comparative analysis with the help of financial ratios would help you in investing.
“Goals of investing is to minimize losses and maximizing gains”.
21 Most Important Financial Ratios for Investors
In current terms, there are lots of financial ratios to look at. Following all of them are practically impossible even for most seasoned investors. To simplify the task, we are categorizing them into 3 categories. Three categories talked about would be named Basics, Intermediate, Advanced.
Most used financial ratios on Basic Level
- Earnings Per Share
- Price to Earnings (P/E ratio)
- Dividend Per Share
- Price to Book Ratio
- Debt to Equity
Some of the financial ratios used on the Intermediate level
- Dividend Payout Ratio
- Current Ratio/Liquidity Ratio
- Interest Coverage Ratio
- Sales and Variable cost (Contribution)
- Dividend Yield
Moving to Advanced Level Financial Ratios:
- Return on Total Assets ( ROTA)
- Return on Investments (RoI)
- Net-Profit to Sales ratio
- Inventory Turnover Ratio
- Assets Turnover Ratio
As it is always suggested to move from the basics to advance levels. Let’s first understand the Basic level financial Ratio analysis.
Earnings Per Share is one of the most used financial ratios. To calculate the EPS you just need the Net profit of the company and the Total number of Equity Shares from the companies financial statements and annual reports.
EPS = Net earnings / Total shares outstanding
The EPS shows the amount company is earning on one share. Higher EPS is always desirable. This relation gives you a better idea of the Earning Capacity of the company. However, for loss-making companies EPS would not be available.
You can get better insight by comparing share price with EPS also know as PE ratio. Further, the EPS shall be looked into with the face value of the share if any changes like the splitting of shares, the bonus, or rights are issued because somehow this will change the EPS.
2. Price to Earnings ratio (P/E ratio)
The price to earnings ratio is one of the most heard and one of the most misunderstood ratio by average investors. To calculate P/E ratio you will just need Current Market Price of share and Earnings Per Share (EPS).
P/E ratio = Current Market Share Price/Earnings Per Share
Another quick alternative to find PE ratio:
P/E ratio = Market Cap. of Company/Net Earnings (TTM)
For a value investor, the P/E ratio suggests that how many years it will take for a company to recover the price paid for the current share price with current EPS. For Example, if a company has a PE ratio of 10, then it will take 10 years to earn the same amount of money by the company that we paid to buy a share while considering constant EPS.
An extremely high or low P/E ratio could raise suspicion. A low P/E ratio may signal an underpriced share with better EPS. Where a High P/E ratio may direct that share is over-prices or the EPS is lower.
The best way to look at PE ratio for any particular company is by comparing it with average industry PE. In the case of a company that has 10 years of records, you can compare its own PE with its 10-year average for value investing.
In most cases, EPS increases with time. It increases very fast, especially in a growth company, in this case, for multi-bagger returns it is always recommended to buy at PE less than the profit growth of a company also known as PEG ratio.
The trend may be some times misleading, as there may be a sudden rise or drop in the recent period. Or there may be a sudden jump in the EPS.
However, the P/E ratio is one of the most dependable and Easy ratios to bet upon in value investing.
Dividend Per Share is the amount that the Company pays to Shareholders for an equity share. The dividends are paid to give a part of the profits to the shareholders. To calculate Dividend Per Share you just need total Dividends amount paid by the company and the total number of Equity shares.
Dividend Per Share = Dividend amount Paid by company/Total number of Equity shares
An alternative would be to multiply EPS by dividend payout ratio.
Dividends are extremely desirable when there is an attempt to build Cash inflows. The dividends may be annual (paid once a year) or Interim (paid quarterly/half-yearly).
An extremely high DPS as compared to competitors shall raise suspicion. As there are no legal requirements to pay dividends to equity shareholders. It suggests that the Company has limited investment opportunities. A company paying high dividends will have a better ROE compared if it will not.
4. Price to Book Value ratio (PB ratio)
The Book Value is the value of a Share and the Reserves that come with it. To calculate this, requirements are Book Value and Current Market Price of the share.
PB Ratio = Current Market Shre Price/ Book Value of Share
PB Ratio = Market Cap. of compnay/ (Equity Shares + Reserves)
It informs us of the relation between price and book value. If the PB ratio is equal to 1 then the price and book value are equal. Further, what if the ratio is below 1? The share price is currently below its book value.
PB Ratio is very important when you analyze bank stocks. IT industry has usually a very high PB ratio as compared to other industries.
5. Debt to Equity Ratio
There can be a never-ending debate on this topic. Debt is the loan on the shoulders of the company and Equity is the capital raised by Shares. There is a legal requirement to pay debts and their Interests on their due dates. This gives rise to a financial burden on the Balance Sheet of the Company. However, Equity is not required to be paid until wind up (closing of the company).
This preferential requirement of Law to pay debts before the Equity share capital makes Equity riskier. Therefore, the cost of debt is lower than the cost of equity. That means the Equity shareholders want more returns as compared to the debt holders.
For the formula, you require Total Debt of the company and Total Equity Share Capital of the company. And the mathematical expression would be
Debt to Equity Ratio = Total Debt/Total Equity
For a healthy balance sheet, it should be less than 0.5. However, while investing, you should never invest in a company if it is great than 2. Anything near 0.5 to nill should be preferred.
These were some of the basic ratios that must be looked at by investors.
Now, let’s take the level to the Intermediate ones.
6. Dividend Payout Ratio
The Dividend Payout Ratio is one of the key ratios used in the decision making of the Company. The company pays a lot of attention to this ratio.
Dividend Payout Ratio = Dividend Per Share/Earnings Per Share
Dividend Payout Ratio = Dividend Amounts/Net Earnings
The balance of this ratio is important for both the company and the shareholders. A higher Dividend Payout ratio means that the company would have fewer funds to finance its further growth activities. Whereas, the lower ratio would lead to discomfort for the shareholders who own stock as a source of income. Hence, the balance of the Dividend Payout Ratio is extremely important for both i.e. companies and shareholders.
7. Current Ratio/liquidity ratio
The current ratio is another important ratio for analyzing a company. To calculate the current ratio you will need total current assets and total current liabilities of the company.
Current Ratio = Current Assets/Current liabilities
Current Assets are the assets that would be converted to cash within 1 year and Current liabilities are the liabilities that would be required to be paid within 1 year.
The current Ratio which is equivalent to 1 is considered healthy. It tells about whether the company’s current assets would be able to pay off its liabilities or it would need to liquidate its fixed assets. Liquidating the fixed assets would be the last option for the company and this move hampers its reputation and share price drop drastically.
8. Interest Coverage Ratio and Debt Coverage Ratio
Interest coverage ratio may be simply defined as how easily and conveniently the company may pay its interest. Sometimes it is almost impossible to run a company without taking debts from the banks and the NBFCs’.
But the convenience of debt brings the cost of interest with it. Further, there is always a threat to get trapped in a debt trap.
Interest Coverage Ratio = Earnings Before Interest and Tax (EBIT)/ Interest
If the ratio is 5 it means that the company is earning 5 times the amount of interest before paying taxes.
Whereas, the Debt coverage ratio moves a step forwards and talks about the Principal as well as the Interest installment of the debt.
Debt Coverage Ratio = EBITDA/(Interest + principal due to the debt)
Higher these ratios better the company’s ability to deal with the debt and its consequences.
9. Sales To Variable Cost (Contribution Ratio)
Let’s learn this by an example. Suppose you receive an order to make a Samosa, which you will make by yourself. You sell it at ₹10 per piece and suppose the cost of potatoes, oil, maida, and other raw material would be around ₹6. So what would be your profit?
Is it ₹10. Surely not, it would be ₹4. The above deal will contribute only ₹4 to your pocket. Hence, your contribution would be 40% (₹4/ ₹10*100) of sales. This information would be very important in your business as well as the company you are looking for investment.
On a larger scale, the companies also notice this type of simple ratio. To calculate this ratio you would need only your sales price per unit and variable Price per unit.
Contribution Ratio = (Sales –Variable cost)/Sales
Any deal in which Variable cost is above Sales cost will take the money out of your pocket. A Higher Contribution ratio tells us that the company is very efficient in managing its sales and variable costs. It is also known as the GP ratio in laymen’s terms.
10. Dividend Yield ratio
The dividend yield ratio may be considered as one of the investors’ favorites for those who own stocks for regular cash flow. This ratio is of better importance to shareholders than to the company.
To calculate Dividend yield you need the Current Market price of the share and the last declared dividend (annual).
Dividend Yield Ratio = Dividend Per Share* 100/ Current Share Price
Dividend Yield Ratio = Dividend Amount (Annual)*100/Market Cap.
The ratio can be simply said as the Annual returns in the forms of the dividend from the company where the investment is the shares price you’ll invest. The higher Dividend yield is always sought after by the investors who mainly invest for cash flow.
This concludes the Intermediate level of Ratio analysis.
Your patience and effort for reading this ratio analysis article at that point are highly appreciated. Now, let’s take the big guns out. It’s time for the Advance Level ratios.
11. Return on Total Assets (ROTA)
Return on total assets is one of the very important financial ratio. It informs the company about its total returns on all the projects and business activities while comparing it to the total assets of the company. The ingredients for the formula are Earnings Before Interest and Taxes (EBIT) and Average Assets Employed During the year.
ROTA = EBIT/Average Assets Employed
Where; Average Assets employed are (Opening Assets + Closing Assets)/2
Higher the ROTA of the company, better the companies chance to increase their earnings by employing more assets. Suppose a Company has a ROTA of 20%, this implies that the company can earn an extra ₹20 crore by investing ₹100 in its assets.
12. Return on Investments (ROI)
Return on Investments is important for shareholders as well as companies. Moving to the Shareholder’s perspective, the formula would require Amounts like The growth/reduction in share price, the dividend paid by the company during the year, and the share price.
To calculate ROI use this formula,
ROI = (Dividend Received + Growth in Share price – Reduction in share price)/Share price at the time of investment
This formula will help you to calculate the returns by investing in the company in absolute terms.
Moving to the example, imagine if you purchase a Share at ₹100, after 1 year you get ₹10 dividends and the share price grows to ₹120. Then your gains would be (10+ (120-100)/100) i.e. 30%.
13. Net profit to sales ratio
Going back to the samosa deal we talked about in contribution ratio. If a company chooses to do the business they don’t need only the Variable Costs.
They need working laborer teams, sales team, marketing team, quality control team, administrative team. The relative importance of the Contribution ratio starts to diminish
In such cases the Net Profit to Sales ratio steps into the limelight. This ratio can be calculated by Dividing the Operational Net Profits by Sales.
Net profit to sales ratio = Net Operational Profit/Revenue
Higher the Net Profit to Sales ratio, higher the effect of increment in the EPS or Final Earnings of the company.
14. Inventory Turnover Ratio
Inventory turnover ratio is one of the best indicators to determine the health of the company. It indicates how many times the company can convert its inventory to cash.
The calculation of the ratio is as follows,
Inventory Turnover Ratio = Sales/ Average inventory held
where; Average Inventories held are (Opening inventory + Closing inventory)/2
If the ratio is equal to 10 then the company can convert its inventory in cash 10 times a year. In other words, it would take nearly take 36.5 Days (365/10) to sell its current stock.
A low inventory turnover means that the stocks are slow-moving or non-moving, also induce the risk of loss of stock by expiry, fire, or theft. A higher inventory turnover must be preferred.
15. Assets Turnover Ratio
On a similar note to the previous financial ratio, this one talks about assets instead of the inventory. It compares how the assets are in comparison to the sale.
The formula is,
Assets turnover ratio = Sales/Average assets
where; Average assets are (Opening assets + Closing assets)/2
The derivations of this ratio are the same as the previous one so the interpretation.
16. Quick ratio
The quick ratio is one of the financial ratio which can be calculated by just seeing the Balance Sheet of the company. The requirements for the Quick ratio are only the current assets, current liabilities, and the Total Closing Inventory of the company.
Quick Ratio = (Current Assets-Closing Inventory)/Current liabilities
Now, let’s move to the importance of the ratio. Closing inventory is considered to be the least liquid Current asset (i.e. it requires more time to get converted in cash) as compared to the Debtors, Cash, and bank.
Hence, while calculating the quick ratio the inventory is excluded from the Current Assets. Further, the quick ratio implies that before taking the support from the closing inventory how quickly the Current liabilities could be paid off. Ideally, the ratio should be equal to 1 and should never exceed more than 2.
17. Average Collection Period (ACP)
The average collection period is used to express the efficiency of the Collection team of the company. If the period is of 30days, it means that the collection team takes 30 days on average to collect the money from its debtors.
However, this shall be always be seen in comparison to that of the industry’s average. In some industries like the Textile industry, it is expected to have a Higher collection period as compared to the Software industry.
The ingredients of the formula are Average debtors (i.e. Opening + Closing debtors)/2) and Total Sales Revenues.
The formula is as follows,
ACP = Average debtors / (360 days*Total Sales)
A lower Average Collection Period is always desired by the companies and the shareholders. The reason for such a wish is that Almost everything has an Opportunity Cost ( i.e. The Cost of the next best alternative).
18. PEG ratio
PEG stands for the Price-Earnings-Growth ratio. It is used to co-relate all three effectively. The formula requires the P/E ratio and Earnings Growth Rate.
The formula is,
PEG Ratio = (P/E ratio)/Earnings Growth Rate
Usually, the P/E ratio acts as a conformant to the growth rate of the company. And if there are any abnormalities the same would be visible in the PEG ratio. Usually, lower PEG (< 1) suggests you undervalued the company with a Good Growth rate and Vice versa.
19. Dividend Retention Ratio
Just like the dividend payout ratio tells about what part of the EPS is paid as Dividends, dividend retention ratio tells about what is not paid in earnings and retain for company future and growth.
Dividend Retention Ratio = 1 – (Dividend Per Share/Earnings Per share)
Dividend retention ratio = 1 – Dividend payout ratio
A higher dividend retention ratio signifies growth opportunities or the un-availability of excess cash. And on a similar note, a lower ratio suggests that there are no many growth opportunities or extra cash reserves in the current financial year.
RoE stands for Return on Equity ratio. This ratio compares the utilization of the Equity of the company with the net income of the company.
The Formula is as follows,
ROE = Net income/(Average or Closing Shareholder’s Equity)
If the RoE is high then the company is getting good returns on the money of you and vice versa. It is always better to calculate the above ratio by considering the average equity, however in unavailability the Closing equity can be used.
If a company having too many debts, in this case, you must have to look at ROCE.
This financial ratio is a lot similar to the previous one (i.e. RoE). It just takes the RoE forward whereas the RoE only concentrates on the equity, this ratio works on the Equity + Long term debts.
They show the returns on the total Capital Employed.
ROCE = EBIT/ Average capital employed
The Capital employed considers both the Long Term Debts as well as Equity.
By comparing, ROE and ROCE you will get a better idea of its debt whether the company utilizing its debt or not.
22. Stock Price To Sales
This financial ratio is used to measure the effect of a rise or decrease in sales on the stock prices of the company. If the ratio is almost the same when compared to the past sales then the company is highly sensitive to change in sales.
The formula is,
Stock Price to Sales = Market Cap/ Revenue of the company
The companies that are only dependent on the sales of their products for revenue are highly sticky with this ratio.
This formula is,
EV/EBITDA = Enterprise Value/ Earnings Before Interest Tax Depreciation and Amortization
You can use it to find the return on total company funds, which includes Equity, Debt, Short term Debt, Minority Interest, etc.
The enterprise value is the entire value of the firm that includes all its tangible/Intangible assets, Subsidiaries, Foreign investments, etc. a higher ratio shall be given preference just like PE ratio.
In the volatile markets, there are lots of simultaneous things going on. However, following these financial ratios may save you time and from huge losses. Investors need to be very careful while investing.
It is always recommended to gain knowledge before investing even a penny. Investing in your knowledge before investing in the stock market would give you unexpectedly higher returns.
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