9 Important Financial ratios you should know about being an Investor
When valuing a business, investors are always looking for that one golden key figure that may be found by looking at a company’s financial statements. Finding a business that checks all of the boxes, on the other hand, isn’t easy.
A variety of financial statistics may be examined to determine a company’s overall financial health and the possibility that it will continue to operate as a sustainable corporation. Financial ratios, which connect and compare the many data on a company’s Balance Sheet and Income Statement, are more important than stand-alone metrics like total debt or net profit. The overall trend of financial ratios, and whether or not they are improving over time, is another something to think about.
To accurately analyse a company’s financial health and long-term survival, several financial parameters must be reviewed simultaneously. The four main factors of financial soundness to consider are liquidity, solvency, profitability, and operational efficiency. However, of the four factors, profitability is probably the most accurate indicator of a company’s health.
Metrics are very helpful when deciding whether to make investment in a company. Used by both private investors and professional analysts, there are many indicators to choose from. Financial indicators are typically divided into four groups:
1.Ratios of profitability
2.Ratios of liquidity
3.Ratios of solvency
4.Multiples or valuation ratios
Despite the best efforts of investors, there is no ideal way to measure a company’s financial position, not to mention the sustainability of the company.
However, there are four important areas of financial soundness where you can thoroughly examine the signs of strengths or weaknesses.
Liquidity, solvency, profitability and operational efficiency are all important factors to consider and should be considered together.
In this post, we’ll go over each area and provide you with some examples of easy-to-understand ratios that will help you quickly learn about firms you might want to invest in.
In financial analysis, ratios—one variable divided by another—are commonly employed to understand how organisations are performing internally and in comparison to one another.
Financial ratios, which are based on data from financial statements such as the balance sheet and income statement, are at the heart of basic analysis.
Profitability, liquidity, solvency, and valuation are the four most popular types of measurements employed in ratio analysis.
The price-to-earnings (P/E) ratio, net profit margin, and debt-to-equity (D/E) ratio are all examples of ratios.
Profitability is an important criterion to consider when considering a business. High sales do not necessarily mean high profitability or high dividends.
While liquidity, fundamental solvency, and operating efficiency are all significant aspects to examine when analyzing a firm, the bottom line is its net profitability. Companies can run for years on the goodwill of creditors and investors without ever making a profit. A corporation, on the other hand, must attain and sustain profitability in order to survive in the long run.
Because a single rupee of profit is insufficient to measure a company’s financial health, the net margin ratio, or the ratio of net profits to total sales, is a good indication for analyzing profitability.
Even though a corporation reports a net profit of several hundred crore rupees, if that figure implies a net margin of barely 1% or less, even the smallest rise in operational costs or marketplace competition might send the company into the red.
A higher net margin, especially when compared to industry peers, suggests a higher financial safety margin as well as a stronger financial position to invest in development and expansion.
Profitability analysis, in general, aims to examine corporate productivity from a variety of perspectives utilizing a few distinct scenarios. Profitability ratios can help you understand how much profit a firm makes and how that profit connects to other critical company data. These are used to use point-in-time data to assess the potential of a company to achieve profits over time in terms of sales, operating expenses, balance sheet assets, and capital.
The following are some crucial profitability ratios:
-Gross margin (and adjusted gross margin)
-Net profit margin
-Operating cash flow margin
-Return on assets (ROA)
-Return on equity (ROE)
-Return on invested capital (ROIC)
-Return on investment (ROI)
1.Net profit margin
One of the most commonly used indicators by investors to quickly assess profitability is the net profit margin.
Net Income divided by Revenue is equal to Profit Margin
Profit margin = Net Income
The net income to revenue ratio is a measurement of a company’s net income in relation to its revenue. The higher profit margin of a company is considered better.
A corporation with a net profit margin of one, or 100 percent, is converting all of its sales into net profits.
Profit margins vary by industry and historical period since this ratio is influenced by a variety of factors. As a result, comparing a company’s net profit margin to the industry and its historical average is also beneficial.
When it comes to net profit margin, there are a few red flags to look out for, especially if the company’s profit margins are dropping year over year. This frequently indicates shifting market circumstances, increased competition, or growing expenses.
If a company’s profit margin is extremely low, it may need to focus on cutting costs through large-scale strategic initiatives. A large profit margin compared to the industry might suggest a major advantage in economies of scale, or it could imply certain accounting strategies that aren’t long-term viable.
Liquidity is an important factor to consider when assessing a company’s core financial position. The amount of cash and assets that can be easily converted to cash that allow a company to meet its short-term debt is called liquidity. Business must first be able to survive in the short term before it can grow in the long term.
Liquidity refers to a company’s capacity to pay off its debts rapidly. It also demonstrates how well the company’s assets support its costs.
Investors can use liquidity indicators to determine how efficient a company’s operations are. It shows how quickly and aggressively a company can make money to acquire more assets or repay creditors during an emergency or normal business operation.
The following are some of the most important liquidity ratios:
-Cash conversion cycle (CCC)
-Operating cash flow ratio
-Working capital turnover
-Quick & Current Ratios
The current and quick ratios are excellent tools for determining a company’s liquidity. Both ratios are nearly identical.
Divide current assets by current liabilities to get the current ratio. Because current assets and current liabilities suggest activity in the next 12 months, this ratio may provide insight into the firm’s short-term liquidity. A greater current ratio is preferable since it indicates how many times current assets can pay current obligations.
Current ratio = Current assets
3. Quick Ratio
The quick ratio is similar to the current ratio, except that it excludes inventory from current assets. By excluding inventory from current assets, this provides a better picture of the company’s short-term liquidity. Again, a faster ratio is desirable. A fast-paced relationship, often referred to as an acid test, is more cautious of the two. This is because inventory is excluded from assets and the current portion of fixed liabilities is excluded from liabilities.
As a result, you can gain a more accurate or practical understanding of a company’s ability to meet short-term obligations using cash and existing assets. A quick ratio less than 1.0 is usually a red flag, indicating that your current liabilities exceed your current assets.
Quick Ratio = (Cash and cash equivalents + Marketable securities + accounts receivable)
Quick ratio = (Current Assets – inventory – prepaid expenses)
Ratios of Solvency
Solvency is related to liquidity since it refers to a company’s capacity to fulfill its financial commitments on a long-term basis rather than merely in the near term. A company’s long-term debt is compared to its assets or equity using solvency measures.
Solvency ratios, often known as leverage ratios, are used by investors to evaluate a company’s capacity to satisfy long-term financial obligations. As you might expect, a company with a lot of debt is less appealing to invest in than one with a little amount of debt.
Financial ratios are frequently used to assess a company’s capital structure and current risk levels, notably in terms of debt and default or bankruptcy risk. Investors utilize these measures while deciding whether or not to invest in a firm. The capacity of a corporation to manage its outstanding debt is crucial to its financial stability and ability to operate. Debt levels and management have a substantial influence on a company’s profitability, as debt servicing costs limit the net profit margin and prevent funds from being invested in expansion.
The debt-to-capital ratio, the debt-to-equity (D/E) ratio, the interest coverage ratio, and the net debt-to-equity (N/E) ratio are some of the financial measures often used by investors and analysts to analyse a company’s financial risk level and overall financial health.
Risk ratios are used to inform investment decisions by taking into account a company’s financial health.
If a corporation utilities revenues to service debt, those money cannot be used to stimulate development elsewhere within the company, putting the organisation at danger.
The interest coverage ratio, the degree of combined leverage, the debt-to-capital ratio, and the debt-to-equity ratio are the most frequent measures used by investors to assess a company’s risk profile.
Because it measures debt against shareholders’ equity, the debt-to-equity (D/E) ratio is a good indication of a firm’s long-term viability. It’s also a measure of investor interest and trust in a company. A lower D/E ratio indicates that shareholders, rather than creditors, are funding more of a company’s activities. This is beneficial to a business since shareholders do not charge interest on the funds they supply.
The D/E ratio varies greatly by industry. A declining trend in the D/E ratio over time, regardless of the unique form of a firm, is a positive sign that a company is on an increasingly sound financial basis.
The following are some of the most prominent solvency ratios:
-Debt to total assets
-Debt to equity
-Times interest earned
-Interest coverage ratio
-Net income to liabilities
The debt-to-asset ratio and the debt-to-equity ratio are two popular ratios for quickly assessing a company’s debt levels. Both examine how debt compares to other financial categories on the balance sheet.
4.Debt to Assets
The total-debt-to-total-assets ratio is used to calculate how much of a company’s assets is encumbered by debt.
The formula is as follows:
Total Debt to Total Assets = Short term debt + Long term debt
The Debt-to-Capital Ratio (DCR) is a measure of how much debt a company has
The debt-to-capital ratio is a leverage ratio that demonstrates how a company’s financial structure funds its operations. A company’s financial health is measured by its debt-to-capital ratio.The entire short-term and long-term debt liabilities of a corporation are compared to the total capital provided by both shareholders’ stock and debt financing in this ratio.
Debt/Capital = Debt/(Debt + Shareholders’ Equity)
Lower debt-to-capital ratios are favored since they reflect a greater share of equity vs debt funding.
6. Debt-to-Equity Ratio
The debt-to-equity ratio compares how much debt a firm has to how much equity it has.
The debt-to-equity ratio (D/E) is a crucial financial measure that compares debt and equity financing in a more direct way. This ratio can also be used to determine a company’s capacity to satisfy its debt commitments.
Debt/Equity = Debt/Equity of Shareholders
A smaller ratio indicates that the company is paying its activities with its own resources rather than borrowing money.Companies with stronger equity balances are often better positioned to withstand transitory revenue dips or unforeseen capital expenditure demands. Higher D/E ratios may make it more difficult for a corporation to get extra funding when it is needed.
A greater debt-to-equity (D/E) ratio may make it more difficult for a corporation to get future financing.
7. Interest Coverage Ratio
The interest coverage ratio is a key metric for determining a company’s ability to handle short-term borrowing costs.. The ratio value indicates how many times a company’s current profits before interest and taxes can cover the needed yearly interest payments on its existing debt (EBIT). A lower coverage ratio suggests that the firm has a bigger debt service burden and, as a result, a higher chance of default or financial collapse.
Interest Coverage =EBIT/Interest Expense
A lower ratio shows that the company has a lesser amount of earnings available to make financing payments and is less able to endure interest rate hikes. An interest coverage ratio of 1.5 or below is indicative of possible financial difficulties with debt repayment.. A high ratio, on the other hand, might indicate that the company isn’t maximizing its financial leverage.
Investors believe that a firm with an interest coverage ratio of 1.5 or less is more likely to experience debt servicing troubles.
8. Degree of Combined Leverage
By taking into account both operating and financial leverage, the degree of combined leverage (DCL) gives a more full picture of a company’s entire risk. This leverage ratio examines the combined effect of both business and financial risk on the company’s profits per share given a particular increase or decrease in sales (EPS). This ratio can help management figure out what levels and combinations of financial and operational leverage are suitable for the organisation.
DCL = Percent change in Earnings Per Share (EPS)/Percentage change in Sales
A company with a high degree of combined leverage is considered riskier than one with a lower level of combined leverage since high leverage indicates the company has higher fixed costs.
A score that is closer to zero is typically preferable since it indicates that a firm has less debt in relation to its overall assets. The better the assets, the more solvent they are. When a corporation is forced to liquidate, lenders often have first claim on its assets; hence, a lower debt/assets ratio signals lesser risk.
When analyzing a firm with this ratio, it’s important to consider both the company’s growth phase and the industry as a whole. Because it hasn’t had a chance to pay off its debt, it’s not unreasonable for a younger firm to have a debt-to-total-assets ratio closer to one ,with more of its assets financed by debt.
Ratios of Valuation
Some of the most widely referenced and simply utilized ratios for determining the attractiveness of a firm investment are valuation ratios. These metrics largely use a firm’s publicly traded stock price to inform investors about how cheap or costly the company is in the market.
In general, the smaller the ratio, the more appealing a company’s investment becomes. Analysts commonly use the reciprocal of a valuation ratio, or its multiple, as a measure of relative worth.
The following are some examples of popular valuation multiples:
One of the most well-known valuation factors is the price-to-earnings (P/E) ratio. On a per-share basis, it compares a company’s stock price to its earnings. The price to earnings ratio, like other valuation ratios, reflects the premium that the market is ready to pay.
The following formula is used to compute the P/E ratio:
Price to Earning = Market Value per Share
Earnings Per Share (EPS)
This ratio converts a company’s earnings into a metric that can be readily compared. In a nutshell, it shows how much investors are ready to pay for a dollar of earnings in that firm. The greater the ratio, the more eager investors are to invest.
However, don’t assume that a greater P/E ratio indicates that a company’s stock is overvalued.Because the P/E ratios of different industries differ greatly, comparing a company’s P/E ratio to that of its industry is crucial.
The financial performance of a corporation is determined by its operational efficiency. One of the strongest markers of efficiency is the operating margin. After removing the variable expenses of manufacturing and promoting the company’s products or services, this statistic analyses a company’s fundamental operating profit margin. It also shows how successfully the company’s management can keep costs under control.
A company’s long-term viability depends on good management. Good management can overcome a variety of transitory issues, but poor management can cause even the most promising firm to fail.
Companies use ratios as a point of comparison. They assess stocks within a certain industry. Similarly, they compare a company’s current performance to its previous results.
In most situations, understanding the elements driving ratios is also crucial since management has the opportunity to change its strategy to make the company’s stock and ratios more appealing. In general, ratios are employed in conjunction with other ratios rather than on their own. Having a strong understanding of the ratios in each of the four areas previously stated will provide you with a comprehensive picture of the organisation from many perspectives and assist you in spotting possible red flags.
The data you’ll need to calculate ratios is readily available, as every number and figure in a company’s financial records can be discovered.
Once you get the raw data, you can immediately input it into your financial analysis software and start putting those figures to work for you.
Everyone wants a competitive advantage when it comes to investing, yet one of the most effective instruments is typically misunderstood and ignored by newcomers. Understanding what ratios mean and where to get all the data you need to calculate them might help you feel more confident in your financial selections and perhaps prevent huge losses.
A company’s total financial and operational health cannot be determined by a single statistic.
Liquidity indicates a company’s capacity to weather short-term storms, whereas solvency indicates how easily it can meet longer-term debt and commitments. Meanwhile, efficiency and profitability speak to the company’s capacity to turn inputs into cash flows and net profits.
To acquire a thorough and holistic assessment of a company’s stability, all of these aspects must be evaluated.
In fundamental analysis, financial ratios are used to evaluate firms and estimate their share values. Certain financial measures may be used to assess a company’s risk, particularly when it comes to fulfilling debts and other commitments in the short and long term.
Bankers use this research to issue further loans, and private equity investors use it to pick which firms to invest in and how to utilize leverage to pay off debt or increase returns on investments.
Edited and published by Ashlyn Joy