Key Financial Ratios To Know Before Investing

Ratio analysis is an excellent method for determining the general economic condition of a company’s business. Ratios are useful for making comparisons between a company and other businesses in that industry. Each of the following ratios is important in helping investors make informed decisions about their investments.

The 5 Categories of Financial Ratios:

All financial ratios fall under one of five categories. By learning about each of these five categories, you'll know which financial ratio calculations to use when you want to start assessing and analyzing potential investment targets.

Market Value Ratios: Market value ratios help evaluate the economic status of publicly traded companies and can play a role in identifying stocks that may be undervalued, overvalued or priced fairly.

  • Price to Earnings Ratio—The P/E Ratio: The price to earnings ratio, also known as the p/e ratio, is probably the most famous financial ratio in the world. It is used as a quick way to determine how "cheap" or "expensive" the stock is. The best way to think of it is how much you are willing to pay for every ₹1 in earnings a company generates.
  • Earnings Per Share: Earnings per share (EPS) measures the net income earned on each share of a company's common stock. To calculate earnings per share, divide the company's net income by the number of outstanding shares (the stock currently held by all shareholders). For example, if a company has ₹10 crores in net income and ₹4 crores in outstanding shares, the earnings per share would be ₹10 crores divided by ₹4 crores, which amounts to ₹2.50.
  • Dividend Yield Ratio: Analysts arrive at the dividend yield ratio by dividing the total dividend payments paid per year by the market price of the stock. For example, if a company pays out dividends quarterly in the amounts of ₹2.25, ₹2.50, ₹2.50, and ₹2.75, the total dividend payments for the year would be ₹10. If the price of the stock is ₹100, you would divide ₹10 (dividend payments) by ₹100 (stock price). The answer is 0.10, or 10%.
  • Book Value Per Share: The book value is a company's equity (not including preferred stock) divided by the shares outstanding in the market. For example, if a company's total assets equal ₹15 crores and its total liabilities equal ₹5 crores, the total equity would be ₹10 crores. If the company has ₹2 crores in preferred stock, deduct that to get ₹8 crores, the amount available to common shareholders. If there are 1 crore outstanding shares, the book value per share would be ₹8, or ₹8 crores divided by ₹1 crore.

Liquidity Ratios: These ratios indicate the convenience of turning current assets into cash. Liquidity means a company's ability to meet current obligations with cash or other assets that can be quickly converted into cash. Liquidity ratios give an indication of a company's ability to retire debts as they come due. Liquidity Ratios include the Current Ratio and the Quick Ratio.

  • Current Ratio: Just like the price to earnings ratio, the current ratio is one of the most famous of all economic ratios. It serves as a test of a company's economic strength and relative efficiency. For instance, you can tell if a company has too much, or too little cash on hand. The current ratio is one of the best-known measures of economic liquidity and is the standard measure of any business' economic health. It tells you whether your business is able to meet its current obligations by measuring if it has enough assets to cover its liabilities.
    The Current Ratio formula is the Current Ratio = Current Assets / Current Liabilities
  • Quick Ratio: This ratio subtracts inventories from current assets, before dividing that figure into liabilities. The idea is to show how well current liabilities are covered by cash and by items with a ready cash value. It's also an acid test. Whereas inventory takes time to sell and convert into liquid assets.  It is a more arduous version of the current ratio indicating whether current liabilities could be paid without having to sell inventory.
    You can calculate the Quick Ratio from balance sheet data with this formula: Quick Ratio = (Current Assets - Inventory) / Current Liabilities

Leverage Ratios: Leverage ratios measure the relative contribution of stockholders and creditors. Leverage ratios indicate the extent to which the business is reliant on debt financing (debts owed to creditors versus the owner's equity). Leverage ratios show the extent to which debt is used in a company's capital structure.

  • Debt to Equity Ratio: The debt to equity ratio is important because investors like to compare the total equity (net worth) of a company to its debt obligations. For instance, if you own ₹100 crores worth of hotels and have ₹30 crores in debt, you are going to be less concerned than if you have the same ₹30 crores in debt with only ₹40 crores worth of real estate. This ratio shows how much the company is leveraged (in debt) by comparing what is owed to what is owned. A high debt to equity ratio could point out that the company may be over-leveraged, and should look for ways to reduce its debt.
    The Debt to Equity Ratio formula is Total Liabilities / Total Equity.
  • Interest Coverage Ratio: The interest coverage ratio is an important financial ratio for firms that use lots of debt. It lets you know how much money is available to cover all of the interest expenses a company incurs on the money it owes each year. This ratio indicates what portion of debt interest is covered by a company's cash flow. The interest coverage ratio formula is Earnings Before Interest, Taxes, Depreciation, and Amortization divided by Interest Expense.

Profitability Ratios: Profitability ratios contain a gaggle of metrics that assess a company's ability to get revenue relative to its revenue, operating costs, record assets and shareholders' equity. Profitability refers to a company's ability to get revenues in more than the prices incurred in producing those revenues.

Margin Ratios: Profit Margin

  • Gross Margin Ratio:  Gross margin measures how much a company can mark up sales above the cost of goods sold (COGS). The gross profit margin measures a company's manufacturing or production process efficiency. It tells managers, investors and other stakeholders the percentage of sales revenue remaining after subtracting the company’s cost of goods sold.
    Gross Profit = Gross Profit / Total Sales
  • Operating Income Ratio: Operating income, also called operating profit, represents the total pre-tax profit a business has generated from its operations. It is the percentage of sales left after covering additional operating expenses. To calculate the operating margin, divide your operating income result from above by total revenue. 
    Operating Margin = Operating Income / Sales
  • Net Profit Ratio: The net profit margin tells you how much after-tax profit the business keeps for every rupee it generates in revenue or sales. A higher net income margin shows more efficiency of the corporate at converting its revenue into actual profit.
    The formula for computing the Net margin of profit is: Net Profit / Net Sales

Return Ratios: 

  • Return on Assets (ROA):  Where asset turnover tells an investor the total sales for each ₹1 of assets, return on assets or ROA tells an investor how much profit a company generated for each ₹1 in assets. Return on Assets (ROA) is an indicator of how well a corporation utilizes its assets, by determining how profitable a corporation is relative to its total assets. Higher ROA indicates more asset efficiency. ROA is calculated by dividing a company’s net by total assets.
    As a formula, it would be expressed as Net Income /Average Total Assets
  • Return on Equity (ROE): Return on equity reveals what proportion of after-tax income a corporation earned as compared to the entire amount of shareholder equity found on the record. In other words, it conveys the percentage of investor money that has been converted into income, giving a sense of how efficiently the company is handling their money. Return on equity is calculated by taking the firm's net earnings (after taxes), subtracting preferred dividends, and dividing the result by common equity rupees within the company.
    The Return on Equity Ratio formula is Net Income / Shareholders Equity

Efficiency Ratios: Efficiency ratios measure a company's ability to use its assets and manage its liabilities effectively. Common efficiency ratios include:

  • Asset Turnover Ratio: The asset turnover financial ratio calculates the total sales generated by each rupee of assets a company owns. In other words, it measures how efficiently a corporation has been using its assets. 
    Asset Turnover Ratio = Net Sales / Total Assets
  • Inventory Turnover Ratio: The inventory turnover ratio measures how many times a company’s inventory is sold or replaced over a given period. Analysts use the ratio to work out if there are enough sales being generated to show or utilize the inventory.
    Inventory Turnover Ratio = Cost of Products Sold / Average Inventory
  • Receivables Turnover Ratio: The receivables turnover ratio measures how efficiently a corporation can actively collect its debts and extend its credits. The ratio is calculated by dividing a company's net credit sales by its average accounts receivable.
    Receivables Turnover Ratio = Net Credit Sales /Average Assets

Applying formulae to the investment game may take a number of the romance out of the method of getting rich slowly. But the above ratios could help you pick the best stocks for your portfolio, build your wealth and even have fun doing it.

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