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Chapter 7.2

Financial Ratios Explained

When you invest into stock markets choosing the stocks correctly is very important because performance of these stocks will decide the returns you will get on your investments. There are different ways of analyzing the stocks of these approaches fundamental analysis and technical analysis are used more frequently.

When an investor wants to analyze financial statements it is possible that he may get confused with multiple numbers in the financial statements. To make this task easier financial ratios are used to analyze financial statements. Financial ratios give the investors an organized means of analyzing financial statements.

When an investor wants to analyze financial statements it is possible that he may get confused with multiple numbers in the financial statements. To make this task easier financial ratios are used to analyze financial statements. Financial ratios give the investors an organized means of analyzing financial statements

# 1. Liquidity measurement ratio:

These ratios are used to check whether the company can pay its short term debts or obligations. It is analyzed by comparing the company’s current assets (which can be easily converted to cash) and its current liabilities (which are short term obligations). Higher the coverage of short-term assets better the company is in a position to satisfy its short term debts & its operating expenses. There are different liquidity ratios differences being each ratio uses different assets for calculations.

# a. Current ratio=(current assets/current liability)
This ratio is used to check the company’s current financial position; are the current assets enough to serve the current liabilities of the company. Current ratio below 1 is not a good sign.

#b. Quick ratio= ((cash & equivalent + short-term investment+ accounts receivables)/current liabilities)
 This ratio is more stringent measure than current ratio as it considers only those current assets which can directly be converted into cash it excludes the inventory because it cannot be converted easily into cash to meet the current obligations of the company.

#c. Cash ratio= ((cash & equivalent + short-term investment)/current asset) this ratio is further more stringent than quick ratio to measure liquidity of the company

# 2. Profitability Ratios:
These ratios measure how efficiently a company generates profits from its utilized resources. There are different profit levels in the income statement-- gross profit, operating profit, pretax profits & net profit. The profit margin level compares these profit levels (gross profit, operating profit, pretax profits & net profit) with the sales the company generates in terms of percentage. These ratios give us an indication of the growth prospects of the company. Profitability ratios are further divided into two categories growth ratios and returns ratio.

# 3. Returns Ratio:

a. Return on asset= [Net income + interest*(1-tax rate)] /Average Total Assets)*100

We add interest*(1-tax rate) to Profit after tax (or net income) because loan taken by the company is used to finance the assets which in turn is used to generate profits. So the debt holders (entities who have given loan to the company) are a part of the company. So the interest paid out also belongs to a stake holder of the company. Also, the company benefits in terms of paying lesser taxes when interest is deducted/subtracted from the profits, this are called a ‘tax shield’. For these reasons, we need to add interest while calculating the ROA to account for the effect of tax shield.

b. Return on Equity=(Net profit/Average Shareholders Equity )*100

This ratio indicates how much the company’s shareholders earn on their investment in the company. Higher the ROE better for the investor. But since the denominator of the ratio consists of only equity it does not captures the effect of debt so the company with high ROE but having higher debt is not expectable.

c. Return on capital employed=(Profit before interest & Tax/Total Capital Employed)*100

Total capital employed =long term debt + short term debt + equity capital employed. This ratio reflects the management’s ability to generate profit from its total capital pool which includes equity as well as debt capital.

# 4. Valuation ratios:

Valuation ratios give a comparison between the current stock price and the companies profit making abilities. Here we get an indication that how much is the market paying for the company’s shares and estimate how will be the further trend. The point of valuation ratios is to compare the price of a stock viz a viz the benefits of owning it. These valuation ratios can be used by the analyst to compare the valuation of one company to its competitors.

a.Price/Earnings ratio (P/E) = (Current per share price/Earnings per share)
This ratio tells us how much is the investor willing to pay for the companies earning power. If the P/E ratio is high then the company is overvalued by the market more than its potential to grow and the market forces may bring the share price down or the company might have a high potential for profitability growth.

b.Price/Sales= (Current per share price*share outstanding/Revenue)

This gives an indication of the value of each unit of the company’s revenue. This ratio can be used to compare the value of one company with the industry average or the other companies P/S ratio to make an investment decision.

c. Price to book value= (Current per share price/BV)

Book value (BV) = [Share Capital + Reserves (excluding revaluation reserves) / Total Number of shares] Suppose the book value of a company is Rs.400 Crores, then this is the amount of money the company can expect to receive after it sells everything and settles its debts. Usually the book value is expressed on a per share basis. This is the per share amount the share holder would receive if the company decides to shut down by paying it obligations.

This ratios compares the market value of the stock to the value of its book value. The P/BV indicates how many times the stock is trading over and above the book value of the firm. Clearly the higher the ratio, the more expensive the stock is so lower the P/BV better.

# 5. Leverage ratios:

These ratios give an indication of companies long term debt standing and debt equity mix.

a.Debt ratio=(Total liabilities/Total Assets)*100

This ratio gives an idea how much of the assets are financed with borrowed money lower the ratio better the company’s position from the debt angle.

b.Debt to equity ratio=(Total debt/Shareholders equity)

Here the total borrowings of the company are compared to the equity fund of the company lower the ratio better the company. Higher ratio indicated higher debt compared to equity and could be a concern.

c.Interest coverage ratio= (Profit before interest & tax /Interest expenses)

Where Profit before interest & tax = operating profit – depreciation expense. This ratio indicates how easily a company can repay the interest on its debt higher the ratio better the company’s standing.

Key Takeaways:

  • Financial Ratios is a quick way to identify the health of the company.
  • It is important to know Liquidity, Profitability and Valuation Ratios before starting with the investments.
  • Good knowledge of Financial Ratios will help to choose right shares for investing and help build Wealth.

Next Course of action:

  • Check how a company is performing compared with other companies from its sector based on various parameters and key ratios
  • Visit Direct Speak and watch our experts give their valuable insights about latest happenings from the world of Investing and Markets