Most Important Financial Ratios to Analyze a Company

Most Important Financial Ratios to Analyze a Company.

Most Important Financial Ratios to Analyze a Company


Reading the financial reports of a company can be a very exacting work. The annual reports of many of the company are over 75 pages which consist of a number of financial jargons.
If you do not understand what these terms mean, you won’t be able to read the reports efficiently.
Nevertheless, there are a number of financial ratios that has made the life of investors very simple to analyze a company. Now, you do not need to make a number of calculations and you can just use these financial ratios to understand the gist.

In this post, I’m going to explain important financial ratios for the investors. We will cover different types of ratios like valuation ratios, profitability ratios, liquidity ratios, efficiency ratios and debt ratios.

Valuation Ratios

These ratios are used to find whether the share price is over-valued, under-valued or reasonably valued. Valuation ratios are relative and are generally more helpful in comparing the companies in the same sector. For example, these ratios won’t be of that much use if you compare the valuation ratio of a company in an automobile industry with another company in the banking sector. Here are few of the most important financial ratios to analyze a company.

1. P/E ratio: 

Price to earnings ratio is one of the most widely used financial ratio by the investors throughout the world. The P/E ratio reflects the price currently being paid by the market for each rupee of currently reported EPS. It measures investors’ expectations and market appraisal of the performance of a firm.

P/E ratio = (Market Price per share/ Earnings per share)

PE ratio value varies from industry to industry.

For example, the industry PE of Oil and refineries is around 10-12. On the other hand, the PE ratio of FMCG & personal cared is around 55-50. Therefore, you cannot compare the PE of a company from the Oil sector with another company from the FMCG sector. In such a scenario, you will always find oil companies undervalued compared to FMCG companies.
A company with a lower PE ratio is considered under-valued compared to another company in the same sector with a higher PE ratio.

2. EV/EBITDA

This is a turnover valuation ratio. EV/EBITDA is a good valuation tool for companies with lots of debts.

Here, EV = (Market capitalization + debt – Cash)

EBITDA = Earnings before interest tax depreciation amortization
A company with a lower EV/EBITDA value ratio means that the price is reasonable.

3. PEG ratio:

PEG ratio or Price/Earnings to growth ratio is used to find the value of a stock by taking in Consideration Company’s earnings growth.

This ratio is considered to be more useful than PE ratio as PE ratio completely ignores the company’s growth rate. PEG ratio can be calculated using this formula:

PEG ratio = (PE ratio/ Projected annual growth in earnings)
A company with PEG < 1 is good for investment.
Stocks with PEG ratio less than 1 are considered undervalued relative to their EPS growth rates, whereas those with ratios of more than 1 are considered overvalued.

4. P/S ratio:

The stock’s price/sales ratio (P/S) ratio measures the price of a company’s stock against its annual sales. It can be calculated using the formula:

P/S ratio = (Price per share/ Annual sales per share)

P/S ratio can be used to compare companies in the same industry. Lower P/S ratio means that the company is undervalued.

5. P/B ratio:

The book value is referred to as the net asset value of a company. It is calculated as total assets minus intangible assets (patents, goodwill) and liabilities.
Price to book value (P/B) ratio can be calculated using this formula:

P/B ratio = (Market price per share/ book value per share)

Here, you can find book value per share by dividing the book value by the number of outstanding shares.
As a thumb rule, a company with a lower P/B ratio is undervalued compared to the companies with higher P/B ratio. However, this ratio also varies from industry to industry.

6. Dividend yield:

Dividend Yield is closely related to EPS. While the EPS is based on book value per share, the yield is expressed in terms of the market value per share. The dividend yield is calculated by dividing the cash dividends per share (DPS) by the market value per share, (not price actually paid by investors)

Dividend yield = Dividend per share/Market Price per share * 100

Now, what dividend yield is good?
It depends on the investor’s preference. A growing company may not give good dividend as it uses that profit for its expansion. However, the capital appreciation in a growing company can be large.
On the other hand, well established large companies give a good dividend. But their growth rate is saturated. Therefore, it depends totally on investors whether they want a high yield stock or growing stock.
As a rule of thumb, a consistent and increasing dividend over the past few years should be preferred.

7. Dividend payout:

Companies do not distribute its entire profit to its shareholders. It may keep a few portions of the profit for its expansion or to carry out new plans and share the rest with its stockholders.
Dividend payout tells you the percentage of the profit distributed as dividend. It can be calculated as:

Dividend payout = (Dividend/ net income)

For an investor, a steady dividend payout is favorable. Moreover, dividend/Income investors should be more careful to look into the dividend payout ratio before investing in dividend stocks.

Profitability ratio


Profitability ratios are used to measure the effectiveness of a company to generate profits from its business. Few of the most important financial ratios for investors to validate the company’s profitability ratios are ROA, ROE, EPS, Profit margin & ROCE as discussed below.

1. Earnings per share (EPS)

EPS measures the profit available to the equity shareholders on a per share basis, that is, the amount that they can get on every share held. It is calculated by dividing the profit available to the shareholders by number of outstanding shares. The profit available to the ordinary shareholders is net profit after taxes and preference dividend.
It is calculated using the formula

EPS = (Net Income – Dividends on Preferred Stock) / Average Outstanding Shares

As a rule of thumb, companies with increasing Earnings per share for the last couple of year can be considered as a healthy sign.

2. Return on equity (ROE)

It reflects the rate of return which a firm is able to generate on equity. This is calculated as:
Return on Equity = Net income after tax/Equity
Where
Equity = Equity Share Capital + Reserves and Surplus

It shows how good the company is rewarding its shareholders is. A higher ROE means that the company generates a higher profit from the money that the shareholders have invested. Always invest in companies with high ROE.

3. Return on assets (ROA)

Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets. It can be calculated as:

ROA = (Net income/ Average total assets)

A company with a higher ROA is better for investment as it means that the company’s management is efficient in using its assets to generate earnings. Always select companies with high ROA to invest.

4. Profit margin

Increased revenue doesn’t always mean increased profits. Profit margin reveals how good a company is at converting revenue into profits available for shareholders. It can be calculated as:

Profit margin = (Net income/sales)

A company with steady and increasing profit margin is suitable for investment.

5. Return on capital employed (ROCE)

ROCE measures the company’s profit and efficiency in terms of the capital it employes. It can be calculated as

ROCE= (EBIT/Capital Employed)

Where EBIT = Earnings before interest and tax
Capital employed is the total number of capital that a company utilizes in order to generate profit. It can be calculated as the sum of shareholder’s equity and debt liabilities.
As a rule of thumb, invest in companies with higher ROCE.

Liquidity ratio


Liquidity ratios are used to check the company’s capability to meet its short-term obligations (like debts, borrowings etc.). A company with low liquidity cannot meet its short-term debts and may face difficulties to run its business efficiently. Here are few of the most important financial ratios for investors to check the company’s liquidity:

1. Current Ratio:
It is the most popularly used ratio to judge liquidity of a firm. It is defined as the ratio between current assets and current liabilities.

Current ratio = (Current assets / current liabilities)

While investing, companies with a current ratio greater than 1 should be preferred. This means that the current assets should be greater than the current liabilities of a company.

2. Quick ratio:

It is also called as acid test ratio. Current ratio takes accounts of the assets that can pay the debt for the short term.

Quick ratio = (Current assets – Inventory) / current liabilities

The quick ratio doesn’t consider inventory as current assets as it assumes that selling inventory will take some time and hence cannot meet the current liabilities.
A company with the quick ratio greater that one means that it can meet its short-term debts and hence quick ratio greater than 1 should be preferred.

Efficiency ratio

Efficiency ratios are used to study a company’s efficiency to employ resources invested in its fixed and capital assets. Here are three of the most important financial ratios for investors to check the company’s efficiency:

1. Fixed Assets turnover ratio:
This ratio is used to measure the efficiency with which fixed assets are employed. A high ratio indicates an efficient use of fixed assets. Generally, this ratio is high when the fixed assets are old and substantially depreciated.
Fixed Assets Turnover Ratio = Net Sales/Average Net Fixed Assets

2. Inventory turnover ratio:
Inventory Turnover Ratio: It measures how many times a firm’s inventory has been sold for a year. It is found by:
Inventory Turnover Ratio = Cost of Goods Sold/Inventory

Where Cost of Goods Sold means Sales minus gross profit and ‘Inventory’ implies a stock of goods at the end of the year. This ratio reflects the efficiency of inventory management. The higher the ratio, the more efficient the inventory management (i.e. how quickly/fast the inventory is sold. A high ratio is considered good from the viewpoint of liquidity and vice versa.

3. Average collection period:

Average collection period is used to check how long a company takes to collect the payment owed by its receivables.
It is calculated by dividing the average balance of account receivable by total net credit sales and multiplying the quotient by the total number of days in the period.

Average collection period = (AR * Days)/ Credit sales

Where AR = Average amount of accounts receivable
Credit sales= Total amount of net credit sales in the period
Average collection period should be lower as higher ratio means that the company is taking too long to collect the receivables and hence is unfavorable for the operations of the company.

Debt Ratio

Debt ratios are used to calculate how much debt a company has at its current financial situation. Here are the two most important Financial ratios for investors to check debt:

1. Debt/equity ratio:
It is used to check how much capital amount is borrowed (debt) vs that of contributed by the shareholders (equity) in a company.
As a thumb rule, invest in companies with debt to equity ratio less than 1 as it means that the debts are less than the equity.

2. Interest coverage ratio:

It is used to check how well the company can meet its interest payment obligation. Interest coverage ratio can be calculated by:

Interest coverage ratio = (EBIT/ Interest expense)

Where EBIT = Earnings before interest and taxes
If the interest coverage ratio is less than 1, then it’s a sign of trouble as it means that the company has not enough funds to pay its interests.
Most Important Financial Ratios to Analyze a Company Most Important Financial Ratios to Analyze a Company Reviewed by Rajat Ajmera on 14 July Rating: 5

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