Financial Ratios
We all know how much it is important to select stocks for its fundamental analysis but there are thousands and thousands of stocks on the stock exchange, so, we must know which stocks to pick and not.
For that, we must know some of the ratios so that it's easy for us to sort the good stocks from the market.
Here are some of the important ratios that everyone must use before doing the fundamental analysis.
- Profitability ratios
ROE:- Return on equity is defined as Net profit divided by shareholders equity for the recent financial year.
ROE = NET PROFIT / SHAREHOLDERS EQUITY
This ratio helps us understand the profit generated from the shareholders' funds who invested in the company.
It is a positive sign if the ROE is increasing year on year (YOY).
ROCE:- Return on capital employed helps us to understand the companies profitability and efficiency with which it uses its capital.
ROCE= EBIT / CAPITAL EMPLOYED
EBIT is defined as earnings before interest and tax.
CAPITAL EMPLOYED = TOTAL ASSETS - TOTAL LIABILITY
It's a very good ratio for knowing if the company is utilizing its assets for increasing its profit and not by taking debt (loan).
If you invest in individual stocks, then invest in those with ROE and ROCE more than 15 because you generally get an average return of 12-15 % in equity mutual funds.
Operating profit margin:- It is defined as the operating profit of the company divided by the revenue(net sales) earned by the company for that financial year.
Operating profit is defined as the profit earned by the company after deducting the operating cost like salaries, selling and distribution, etc.
For example, if the operating profit is 20%, it means for every Rs. 100 of revenue it generates rs. 21 of operating profit.
So, the higher the ratio higher the profit.
- Valuation ratio
Enterprise value:- The enterprise value of a company is the total value of a company.
It is calculated as:
EV = (Market cap + Debt) - cash.
Market capitalization = Current share price * No. Of outstanding shares in the market.
PE Ratio:- The price to earnings ratio is the closing price of the stock divided by earnings per share (EPS).
PE is one of the important ratios to value a stock, it tells if the price is overvalued or undervalued. The best way to find if any company is overvalued or undervalued is by comparing the PE of different companies working in the same sector.
But don't just blindly look at this ratio and judge if the price is high or low, check other parameters also from the financial statement of the company. If the financials are good, it means investors are willing to buy the stock at a premium price and this may be one of the reasons the PE of any good company is high.
PB Ratio:- Price to book value also an important ratio for valuing a company, it is calculated by the closing price of a share divided by the book value of the share.
Here the book value is the value of total assets of the company mentioned in the balance sheet.
It is also an important ratio to value a company because it gives an account of money that you will be getting per share after eliminating the liabilities if the company shuts down tomorrow.
This ratio is generally calculated for banking and financial companies since non-banking companies don't carry a large number of assets on their balance sheet.
- Liquidity ratios
These ratios tell us the ability of the company to use its cash to repay the total current liability.
Current ratio:- This ratio is used to determine the ability to pay its short-term debt (loans that must be paid within one year)
CURRENT ASSET = CURRENT ASSET / CURRENT LIABILITY
Current assets are assets such as Cash, inventory and cash receivable.
The higher the ratio the more good is the company because it will be having more assets to pay its current liability. Anything less than one is a very bad indication that the company may not be able to repay its debt.
Quick Ratio:- Quick ratio is used to determine how well the company can repay its debt using its liquid assets such as cash and receivable. Here inventory is not considered as an asset because it's not a liquid asset.
Quick ratio= (Current asset - Inventory) / Current Liability
Higher the quick ratio better the liquidity situation of the company.
Operating cash flow ratio:- It measures the number of times the company can pay its liability within the same period.
If the ratio is greater than 1 then it indicates the company has generated more cash in a period than what is required to pay off its current liability
Operating cash flow ratio = operating cash flow / Current liability.
Both the current and operating cash flow ratio is used to determine the ability of the company to repay the current liability.
But in operating cash flow, it takes cash flow from operation to repay its debt, but current assets are used in the current ratio.
- Leverage ratios
This ratio is used to look at the capital that comes to the company in the form of debt.
Debt to Equity ratio:- This ratio is used to determine how much debt is used capital is used to fund projects and in day to day working expenses of the company.
It's calculated by:
Debt to equity ratio = Total debt / Total shareholders equity
The higher the debt capital used, the higher interest paid by the company hence less profit. So, lower the ratio better the company.
Debt to asset ratio:- This ratio is used to check if the company has enough current to repay its current debt.
Debt to asset = Total debt / Total asset
If the ratio is more than 1 then it has more debt than assets and it is a very bad indication to the company since it may have chances of defaulting.
Interest coverage ratio:- This ratio is used to determine how well a company can pay off the debt of its outstanding debt.
Interest coverage ratio = Operating income (EBIT) / Interest expense
EBIT is defined as earnings before interest and tax.
Interest expense is the amount of money paid to the outstanding debt of the company, the higher the debt higher is the expense.
Higher the ratio better the ability of the company to pay the interest. If the ratio is 1 then all the operating profit will be used to pay the interest and there will be no profit.
So, these some of the important ratios that one must go through before analysing any company.
~By Suddha.
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