In previous videos we went through three main financial statements of a business i.e Income statement, balance sheet and cash flow statement. But the question here arises are these statements enough for an investor to make a decision whether to invest in a certain company? The answer here is no. ratios are another helpful tool that aids in this decision making related to investments.
Financial ratios of a company are used to compare a company’s performance with its past, make future predictions by setting bench-mark and goals, and to compare its growth with other companies in the sector. These ratios are also used to identify changing trends in the business and when it is the right time to make a move in/out of a company. Basically, financial ratios influence the decision making of investors by giving relevant information rather than raw financial information, on whether to invest in a company.
There are different kinds of financial ratios. Let’s discuss them individually:
As the name suggests, these ratios are used to measure how profitable a company has been over the past several years using key figures from financial statement.
Net Profit Margin = Net Profit after Tax/ Sales
It shows the net income was generated by the company from each rupee spent on the sales.
Return on Shareholders Equity = Net Income / Shareholder’s equity
This is a measure of the rate of return shareholders earn on their investment in the company. It is assumed that the higher the ROE, the better the company is at generating profits.
Return on Total Assets = Income from Operations / Average Total Assets:
Another important ratio to analyse the efficiency of assets employed in generating profit
These ratios help determine the returns that a business generates for its investors
Earnings Per Share = Net Income / Number of Shares Outstanding
This signifies the earnings for an equity holder based on the number of shares.
Dividend Per Share = Total Dividends Paid / Shares Outstanding
It measures how much income from the company investors will receive in cash on a per-share basis.
Price to Earnings Ratio = Market Value Per Share (or share price )/ Earnings Per Share
It’s a ratio to relate current share price relative to its earnings. A higher ratio indicates a company’s stock being overvalued or that investors are predicting a high growth rate in the future. For example, a company in the technological sector is likely to have a high P/E ratio because of the confidence investors have in the company’s growth trajectory.
From an investor’s perspective, companies are judged on the basis of their performance rather than size, sales volume or even market share. Ratios go beyond numbers to paint an actual picture of a company. For eg a large, settled company may have a huge revenue but a smaller company, in comparison, may have a higher return on equity, return on assets and net profit margin which reveals that the smaller company is working efficiently, generating more profit per rupee of assets employed
For the same reason some investors are interested in growth and further investments of a company rather than the dividends it is paying off. A mature investor who prefers a steady income would prefer a higher dividend whereas a company with a growth mindset would prefer to re-invest their profits rather than distributing it to its shareholders. Such companies will have a negative cashflow from investing activities and won’t be paying out much in dividends. Such companies usually have a high price to earnings ratio because of their aggressive nature. In contrast, there are many companies that don’t pay dividends at all. These companies have always been transparent with their intent and future goals. According to a yahoo finance report 2021, Alibaba has never paid dividends to its shareholders. Some companies like Boeing have cut off dividends following post pandemic recessions.
Through these financial ratios, it is easy to measure a company’s ability to repay its short-term and long-term obligations.
Some common liquidity ratios are:
Current Ratio = Current Assets / Current Liabilities
This current ratio briefly describes how a company manages to pay off current liabilities given its current assets, within a year.
Acid Test Ratio = (Current Assets – Inventories) / Current Liabilities
It measures how well current liabilities are covered by cash and by items with ready cash since inventories take time to liquidate.
A company’s health and efficiency are also judged by turnover ratios. These tell how sales are generated for example how aggressively fixed assets are used to generate sales or if the company has a light fixed asset model. This is also known as operating leverage. If a company has a higher operating leverage, it can increase sales even higher given a certain level of assets.
If a company wants to know how efficiently the assets and liabilities are used to generate revenue then turnover ratios are of great help.
Types of turnover ratios are:
Fixed Asset Turnover Ratio= Net Sales / Average Fixed assets
It represents the ability of a company to generate revenue from its assets, after adjustments of depreciation are made.
Inventory Turnover = Cost of Goods Sold / Average Inventory
It Represents how easily or fast the company is able to convert its inventory into sales.
Receivable Turnover = Net Credit Sales / Average Receivables
It measures how efficiently a company can collect its receivables. A higher ratio indicates a company collecting its receivables in cash.
This compares a company’s debt level to its assets, equity, and earnings to evaluate how efficiently a company is likely to pay off its long-term debts as well as interest on debt. It also highlights how much of a company’s capital comes from debt.
Examples of leverage ratios are:
Debt to Equity Ratio = Total Debt / Total Equity
This ratio measures a company’s leverage to its value as represented by stockholders equity.
Total Debt Ratio = (Total Assets – Total Equity) / Total Assets
An easy way to assess how much of a company’s assets are funded by debt
Interest Coverage Ratio = Earnings Before Interest and Tax / Interest Expense
It represents how successfully a company can pay out interest expense from its profit
In conclusion, the above mentioned ratios are commonly used to compare a company’s performance. These figures help investors, creditors and internal company management understand how well a business is performing and of areas that need improvement.