Financial ratios can help to make sense of the overwhelming amount of information that can be found in a company’s financial statements.
Knowing how to pick out small bits of important information, combine them with other small bits of information and interpret the resulting number is more of an art than a science. But it’s undoubtedly one of the most important arts that an investor should practice. To start your journey into ratio analysis, you’ll need a company’s consolidated financial statements, found in a company’s 10-K and available for free on the Moneycontrol and screener.in website. The three most important financial statements are the income statement, balance sheet and cash flow statement. Track these down before proceeding further.
While there are quite a few financial ratios, investors use a handful of them over and over again. These 15 ratios are indispensable tools that should be a part of every investor’s research process.
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Price Ratios
Price ratios are used to get an idea of whether a stock’s price is reasonable or not. They are easy to use and generally pretty intuitive, but do not forget this major caveat: Price ratios are “relative” metrics, meaning they are useful only when comparing one company’s ratio to another company’s ratio, a company’s ratio to itself over time, or a company’s ratio to a benchmark.
1) Price-to-Earnings Ratio (P/E)
What you need: Income Statement, Most Recent Stock Price
The formula: P/E Ratio = Price per Share / Earnings Per Share
What it means: Think of the price-to-earnings ratio as the price you’ll pay for ₹1 of earnings. A very, very general rule of thumb is that shares trading at a “low” P/E are a value, though the definition of “low” varies from industry to industry.
2) PEG Ratio
What you need: Income Statement, Most Recent Stock Price
The formula: PEG Ratio = (P/E Ratio) / Projected Annual Growth in Earnings per Share
What it means: The PEG ratio uses the basic format of the P/E ratio for a numerator and then divides by the potential growth for EPS, which you’ll have to estimate. The two ratios may seem to be very similar but the PEG ratio is able to take into account future earnings growth. A very general rule of thumb is that any PEG ratio below 1.0 is considered to be a good value.
3) Price-to-Sales Ratio
What you need: Income Statement, Most Recent Stock Price
The formula: Price-to-Sales Ratio = Price per Share / Annual Sales Per Share
What it means: Much like P/E or P/B, think of P/S as the price you’ll pay for ₹ 1 of sales. If you are comparing two different firms and you see that one firm’s P/S ratio is 2x and the other is 4x, it makes sense to figure out why investors are willing to pay more for the company with a P/S of 4x. The P/S ratio is a great tool because sales figures are considered to be relatively reliable while other income statement items, like earnings, can be easily manipulated by using different accounting rules.
4) Price-to-Book Ratio (P/B)
What you need: Balance Sheet, Most Recent Stock Price
The formula: P/B Ratio = Price per Share / Book Value per Share
What it means: Book value (BV) is already listed on the balance sheet, it’s just under a different name: shareholder equity. Equity is the portion of the company that owners (i.e. shareholders) own free and clear. Dividing book value by the number of shares outstanding gives you book value per share.
Like P/E, the P/B ratio is essentially the number of dollars you’ll have to pay for ₹ 1 of equity. And like P/E, there are different criteria for what makes a P/B ratio “high” or “low.”
5) Dividend Yield
What you need: Income Statement, Most Recent Stock Price
The formula: Dividend Yield = Dividend per Share / Price per Share
What it means: Dividends are the main way companies return money to their shareholders. If a firm pays a dividend, it will be listed on the balance sheet, right above the bottom line. Dividend yield is used to compare different dividend-paying stocks. Some people prefer to invest in companies with a steady dividend, even if the dividend yield is low, while others prefer to invest in stocks with a high dividend yield.
6) Dividend Payout Ratio
What you need: Income Statement
The formula: Dividend Payout Ratio = Dividend / Net Income
What it means: The percentage of profits distributed as a dividend is called the dividend payout ratio. Some companies maintain a steady payout ratio, while other try to maintain a steady number of dollars paid out each year (which means the payout ratio will fluctuate). Each company sets its own dividend policy according to what it thinks is in the best interest of its shareholders. Income investors should keep an especially close eye on changes in dividend policy.
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Profitability Ratios
Profitability ratios tell you how good a company is at converting business operations into profits. Profit is a key driver of stock price, and it is undoubtedly one of the most closely followed metrics in business, finance and investing.
7) Return on Assets (ROA)
What you need: Income Statement, Balance Sheet
The formula: Return on Assets = Net Income / Average Total Assets
What it means: A company buys assets (factories, equipment, etc.) in order to conduct its business. ROA tells you how good the company is at using its assets to make money. For example, if Company A reported ₹10,000 of net income and owns ₹ 100,000 in assets, its ROA is 10%. For ever ₹ 1 of assets it owns, it can generate ₹ 0.10 in profits each year. With ROA, higher is better.
8) Return on Equity (ROE)
What you need: Income Statement, Balance Sheet
The formula: Return on Equity = Net Income / Average Stockholder Equity
What it means: Equity is another word for ownership. ROE tells you how good a company is at rewarding its shareholders for their investment. For example, if Company B reported ₹ 10,000 of net income and its shareholders have ₹ 200,000 in equity, its ROE is 5%. For every ₹ 1 of equity shareholders own, the company generates ₹ 0.05 in profits each year. As with ROA, higher is better.
9) Profit Margin
What you need: Income Statement
The formula: Profit Margin = Net Income / Sales
What it means: Profit margin calculates how much of a company’s total sales flow through to the bottom line. As you can probably tell, higher profits are better for shareholders, as is a high (and/or increasing) profit margin.
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Liquidity Ratios
Liquidity ratios indicate how capable a business is of meeting its short-term obligations. Liquidity is important to a company because when times are tough, a company without enough liquidity to pay its short-term debts could be forced to make unfavourable decisions in order to raise money (sell assets at a low price, borrow at high-interest rates, sell part of the company to a vulture investor, etc.).
10) Current Ratio
What you need: Balance Sheet
The formula: Current Ratio = Current Assets / Current Liabilities
What it means: The current ratio measures a company’s ability to pay its short-term liabilities with its short-term assets. If the ratio is over 1.0, the firm has more short-term assets than short-term debts. But if the current ratio is less than 1.0, the opposite is true and the company could be vulnerable to unexpected bumps in the economy or business climate.
11) Quick Ratio
What you need: Balance Sheet
The formula: Quick Ratio = (Current Assets – Inventory) / Current Liabilities
What it means: The quick ratio (also known as the acid-test ratio) is similar to the quick ratio in that it’s a measure of how well a company can meet its short-term financial liabilities. However, it takes the concept one step further. The quick ratio backs out inventory because it assumes that selling inventory would take several weeks or months. The quick ratio only takes into account those assets that could be used to pay short-term debts today.
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Debt RatiosThese ratios concentrate on the long-term health of a business, particularly the effect of the capital and finance structure on the business:
12) Debt to Equity Ratio What you need: Balance Sheet The formula: Debt-to-Equity Ratio = Total Liabilities / Total Shareholder Equity
What it means: Total liabilities and total shareholder equity are both found on the balance sheet. The debt-to-equity ratio measures the relationship between the amount of capital that has been borrowed (i.e. debt) and the amount of capital contributed by shareholders (i.e. equity). Generally speaking, as a firm’s debt-to-equity ratio increases, it becomes riskier because if it becomes unable to meet its debt obligations, it will be forced into bankruptcy.
13) Interest Coverage Ratio
What you need: Income Statement
The formula: Interest Coverage Ratio = EBIT / Interest Expense
What it means: Both EBIT (aka, operating income) and interest expense are found on the income statement. The interest coverage ratio, also known as times interest earned (TIE), is a measure of how well a company can meet its interest payment obligations. If a company can’t make enough to make interest payments, it will be forced into bankruptcy. Anything lower than 1.0 is usually a sign of trouble.
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Efficiency Ratios These ratios give investors insight into how efficiently a business is employing resources invested in fixed assets and working capital. It’s can also be a reflection of how effective a company’s management is.
14) Asset Turnover Ratio
What you need: Income Statement, Balance Sheet The formula: Asset Turnover Ratio = Sales / Average Total Assets
What it means: Like return on assets (ROA), the asset turnover ratio tells you how good the company is at using its assets to make products to sell. For example, if Company A reported ₹ 100,000 of sales and owns ₹ 50,000 in assets, its asset turnover ratio is 2x. For ever ₹ 1 of assets it owns, it can generate ₹ 2 in sales each year.
15) Inventory Turnover Ratio What you need: Income Statement, Balance Sheet
The formula: Inventory Turnover Ratio = Costs of Goods Sold / Average Inventory
What it means: If the company you’re analyzing holds has inventory, you want that company to be selling it as fast as possible, not stockpiling it. The inventory turnover ratio measures this efficiency in cycling inventory. By dividing costs of goods sold (COGS) by the average amount of inventory the company held during the period, you can discern how fast the company has to replenish its shelves. Generally, a high inventory turnover ratio indicates that the firm is selling inventory (thereby having to spend money to make new inventory) relatively quickly.
