Classification of Financial Ratios:
Before investing in a company, it’s prudent to look into the fundamentals of the company and have a clear understanding of the company. Looking at the key financial ratios will help you to compare the company with its peers and understand its financial status.
Financial Ratios are broadly classified into five different categories as listed below:
These financial ratios are used to measure a company’s ability to meet its short-term obligations. It does not just show its cash level but also its ability to convert its assets into cash to meet its short-term obligations. Two commonly used liquidity ratios are:
• Current Ratio
Current ratio is a measure of company’s ability to pay its current liabilities (accounts payable) with its current assets (cash, marketable securities, inventory, accounts receivable). A current ratio of greater than or equal to 1 means company should be able to meet its short-term obligation. This ratio is also called as Working Capital ratio.
Current Ratio = Current Assets / Current Liabilities
• Quick Ratio
One of the limitations with current ratio is that not all current assets may get converted into cash quickly, such as inventories. Quick ratio is an alternate choice to measure the liquidity which does not include inventory and prepaid expenses in its calculation. It is a measure of company’s ability to meet its short-term obligations with its most liquid assets such as Cash, Accounts Receivable, Short Term or Marketable Securities. It is calculated as:
Quick Ratio = Current Assets – (Inventory + Prepaid Expenses) / Current Liabilities
Quick Ratio = (Cash + Accounts Receivable + Short Term + Marketable Securities) / Current Liabilities
Quick ratio of more than 1 indicates that the companies have more quick assets than the liabilities and they don’t have to sell any long-term assets to pay its obligations.
These financial ratios indicate how efficiently a company utilises its assets. They are also referred to as the activity ratios. Efficiency ratio tells the time it takes to convert its sales into cash. Some commonly used efficiency ratios are:
• Accounts Receivable Turnover
It is an evaluation of how quickly a company converts its credit sales into cash or how many times during a year, the company turns its receivables into cash. It is calculated as:
Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable
The higher the ratio, the better it is; as the frequency of collecting receivables will be high and the company will have more cash which can be used to pay its obligations.
• Inventory Turnover
It indicates how many times an average inventory is being sold during a period. Higher inventory turnover means the company is effectively selling its inventory. It is calculated as:
Inventory Turnover = Cost of Goods Sales / Average Inventory
• Assets Turnover
It indicates how efficiently a company is using its assets to generate sales. A ratio of 1 means, for every one rupee investment in assets, the company is making one rupee sales. It is calculated as:
Assets Turnover = Net Sales / Average Total Assets
These financial ratios are an indication of company’s ability to generate profit from its operations. Some of the commonly used profitability ratios are:
• Gross Profit Margin
It is used to calculate the percentage of sales that exceeds the cost of goods sold. It measures how efficiently a company earns, considering the cost incurred in producing its products and services. It is calculated in percentage and is calculated as:
Gross Profit Margin = (Gross Profit / Net Sales) * 100
• Net Profit Margin
It is a ratio of net income to net sales and indicates how much income has been generated by a company after considering all its expenses. A higher ratio indicates that the company is capable of paying back loans to its creditors and distribute dividends to the investors. It is calculated in percentage as:
Net Profit Margin = (Net Income / Net Sales) * 100
• Operating Profit Margin
It is a measure of company’s profit after deducting the cost of goods sold and the operating expenses. It is represented in percentage as a ratio of Operating Income to Net Sales. Operating Income is sometimes referred to as the earnings before interest and taxes(EBIT) and is calculated by subtracting operating expenses, depreciation and amortization from gross income. Higher operating profit margin means, the company is generating more income from its core business operations and is stable.
Operating Profit Margin = (Operating Income / Net Sales) * 100
Operating Profit Margin = (EBIT / Net Sales) * 100
• Earnings Per Share(EPS)
It is the ratio of net income available for the ordinary shareholders to the number of outstanding shares. Preferred dividends are subtracted from the net income while calculating EPS.
EPS = Net Income – Preferred Dividends / Weighted Average Outstanding Shares
Higher EPS means the company has earned more profit and is in a position to distribute the profit to its shareholders.
• Return on Equity(ROE)
It is an evaluation of the return earned on the money invested by the common shareholders in the company. It indicates how efficiently a company employs its equity and is calculated as:
ROE = Net Income / Average Shareholders Equity
Preferred dividends are subtracted from the Net Income as the shareholders equity does not include the preferred shares. An ROE of 1 indicates that every rupee of common shareholders equity has earned one rupee.
• Return on Assets(ROA)
This ratio implies how efficiently a company is using its assets to generate profits during a period. It is expressed in percentage and is calculated as:
ROA = (Net Income / Average Total Assets) * 100
ROA differs between industries as the assets deployed also differ. It is prudent to compare the ROA of companies in the same industry.
• Return on Capital Employed (ROCE)
It is used to calculate the company’s efficiency in generating profits from its Capital Employed and is an indication of long-term profitability of the company as it includes long-term financing. It is expressed in percentage and is calculated as:
ROCE = (Net Operating Profit or EBIT / Capital Employed) * 100
ROCE = (Net Operating Profit or EBIT / Total Assets – Current Liabilities) * 100
You can calculate Capital Employed by deducting current liabilities from the total assets. ROCE should always be higher than the rate at which the company borrows money to fund its assets.
• Earnings Before Interest Taxes Depreciation & Amortization(EBITDA)
It is a measure of company’s financial performance from the earnings generated by its core business operations before deducting the non-operating expenses like interest, taxes and paper expenses like depreciation and amortization. It is calculated as:
EBITDA = Revenue – Expenses (excluding tax, interest, depreciation and amortization)
Higher earnings are always preferred over low as the company will have more money after paying its operating expenses.
• Dividend Yield
It is a measure of how much dividends is paid by a company to its shareholders in a year. It indicates how much a shareholder earns for each rupee of investment. It is expressed in percentage and is calculated as:
Dividend Yield = (Dividend Per Share / Market Price Per Share) * 100
Distributing the dividends is completely dependent on the company based on its strategy. A company may stop paying dividends during adverse economic conditions.
These financial ratios are an indication of market value of stocks on its earnings, book value, sales, etc. It gives an indication of whether the stock is overvalued or undervalued. Some of the commonly used valuation ratios are:
• Price to Earning(P/E) Ratio
It indicates the market price of a share based on its earnings. It is the rupee amount an investor has to pay for each rupee of earnings made by the company and is calculated as:
P/E = Market Price Per Share / Earnings Per Share
P/E Ratio is also referred to as ‘price multiple’ or ‘earnings multiple’. If the investor is willing to pay more, for the earnings of the company, P/E will be high. It means that the investor has high hopes from the company.
• Price to Book(P/B) Ratio
It is a ratio used to find out whether the company’s stock is overvalued or undervalued by comparing the market value of company’s shares to its Net Assets. It indicates how much a shareholder is paying for the company’s net assets and is calculated as:
P/B = Market Price Per Share / Book Value Per Share
Book Value is an estimated value of a company at the time of liquidation. It is calculated by subtracting its liabilities from assets. P/B Ratio of more than 1 indicates that the investors are willing to pay more than the company’s net assets value and the stock is overvalued. On the other hand, if P/B ratio is less than 1, the stocks are undervalued.
• Price Earnings to Growth(PEG) Ratio
It is an evaluation of the value of a stock, considering the potential future growth of the company. This ratio gives a clearer picture of the stock as it considers the growth perspective of the company. PEG of less than 1 is a good bet as the stock will be undervalued and is calculated as:
PEG = Price to Earnings / Annual EPS Growth Rate
• Price to Sales Ratio(P/S) Ratio
It is calculated by comparing the price of a stock to its revenue. This ratio is used for the companies which are in loss as P/E Ratio cannot be calculated for such companies. It is calculated as:
P/S = Price Per Share / Revenue Per Share
P/S = Market Capitalization / Sales Revenue
These financial ratios are used to measure the financial leverage of the company and its ability to meet the financial obligations. Some of the commonly used leverage ratios are:
• Debt to Equity Ratio
This ratio is calculated by dividing the company’s total liabilities by its total assets.
Debt to Equity = Total Liabilities / Total Assets
Higher debt to equity ratio means that the company is highly leveraged by the creditors such as banks, than its shareholders. Debt to equity ratio of 1 means, the investors and creditors have an equal stake in the company.
• Interest Coverage Ratio
It is used to measure the company’s ability to cover its interest obligation using its operating earnings i.e. earnings before interest and taxes(EBIT). Using this ratio, one can calculate the number of times interest payments are made on its debt through EBIT. It is given by:
Interest Coverage = EBIT / Interest Expenses
Interest Coverage ratio of less than 1 implies that the company is not making sufficient money to pay its interest obligations.
The financial ratios mentioned above are the key to analyse a company’s financial health. Understanding these financial ratios will certainly help you take a prudent investment decision.