Most important financial ratios you must know as an investor(6 min read)
Have you ever tried to read the financial report of any company? I did. Actually I tired to read it but I gave up half way. Reading a financial report (balance sheet) is very cumbersome job. It consists of more than 100 pages with number of financial jargons. If you don’t know what these jargons means there is no use of reading it.
To make life simple and easy there are number of financial ratios. You can use these financial ratios to understand the crux of the balance sheet.
Through this post I will try to explain these ratios in a simple language which will help you to make your investment decisions.
To make is easy I have bifurcated ratios into:
- Valuation ratio
- Profitability ratio
- Liquidity ratio
- Efficiency ratio
- Debt ratio
Let’s understand them one by one.
This ratios are helpful to know whether the share price of the company is over valued, under valued or reasonably valued. This ratio is useful in comparing the companies in the same sector. Below are the most important and commonly used valuation ratios to validate company’s valuation.
- P/E ratio
Price to earning ratio one of the most common ratio that investors are using throughout the world. It is calculated by:
P/E Ratio = (Market price per share/Earnings per share)
PE ratio value varies from industry to industry. Meaning every industry has a different PE ratio. For example, industry PE of oil and refineries is 10-12 while PE of FMCG industry is around 50-55. Therefore you cannot compare PE ratio of these two industry.
A company with lower PE ratio is considered as undervalued as compare to the company of the same industry with a higher PE.
- P/B Ratio
It is called price to book value ratio. Before going forward, we need to understand the book value of the company. Book value is nothing but the net asset value of the company. It is calculated as total asset minus total liability and intangible assets like patent and goodwill.
Price to book value ratio can be calculated as below:
P/B ratio =(Market price per share/book value per share)/number of outstanding shares
Same as PE ratio, lower PB ratio is undervalued as compare to higher PB ratio.
3. PEG ratio
This is called price/earning to growth ratio which is used to know the value of the company by considering company’s earning growth. This ratio is more accurate than PE ratio as PE ratio ignores the growth potential of the company. PEG ratio can be calculated as below:
PEG Ratio = (PE ratio/Projected annual earning growth
As a thumb rule, company with < 1 PEG ratio is good for investment.
4. Dividend yield
Dividend is the profit sharing by company to their share holders as decided by board of directors.
Dividend yield = (Dividend per share/Price per share)
In the initial period of the company dividend can be low or zero as company may use the surplus for expansion. At this stage though the company is not giving any dividend it’s growth rate is high.
On the other hand, well established large company is giving dividend but their growth rate is saturated. So as an investor it’s your decision to chose the company.
Profitability ratios are use for knowing the efficiency of the company to generate profit out of its business. Let’s discuss these ratios one by one.
1. Return on Assets (ROA)
Return on assets is an indicator of how profitable a company is against its assets.
It can be calculated as below:
ROA = (Net income/Average total assets)
Companywith higher ROA is good for investment as it means that company ‘s management is efficiently managing its assets to generate maximum returns.
2. Earning per share (EPS)
It’s nothing but the company ‘s earning expressed as a share value. It is calculated as below:
EPS = (Net income – dividend issued on preferred share/Outstanding shares
As a thumb rule, higher EPS is considered as a good company to invest.
3. Return on equity (ROE)
ROE is the amount of Net income returned as a percentage of shareholders equity. It can be calculated as below:
ROE = (Net income/shareholder equity)
It shows how good is the company in rewarding its shareholders. Higher ROE means higher returns. Always invest in the company with high ROE.
4. Return on capital
Return on capital means company ‘s efficiency against its employed capital. It can be calculated as below:
ROC = (EBIT/Employed capital)
Where EBIT = Earnings before interest and tax
Capital employed is the total capital that a company is using to generate income.
Always invest in the company with higher ROC.
Debt ratios are used to understand how much debt a company has against its assets. Below are the two most useful debt ratio.
1. Debt/equity ratio
It is used to check how much debt a company has as compare to its equity. As a thumb rule debt/ equity ratio < 1 is good. It means company’s debt is lesser than its equity.
This ratio as an isolation cannot give exact picture of the company. As in the initial period company has higher debt but also has higher growth rate and return on equity.
2. Interest coverage ratio
It’s used to know the how well company can meet its interest payment obligation. It can be calculated as below:
Interest coverage ratio = (EBIT/Interest expense)
If the interest coverage ratio is <1 then it’s a sign of a trouble that company is not capable to meet its interest payment obligation.
Liquidity ratios are used to check the company’s capability to meet its short term obligations. Company with low liquidity cannot meet its short term obligation and hence may face challenges in running its operations. Below are the ratios investors should check before investing.
1. Current ratio
It tells you the company’s capabilities to pay its short terms liabilities. It can be calculated as:
Current ratio= (Current assets / Current liabilities)
Companies with >1 is preferable for investment. This tells current assets is greater than current liabilities.
2. Acid test ratio
This ratio talks about the assets that can pay debt for the short term.
Acid test ratio = (Current assets – Inventory) / Current liabilities
This ratio doesn’t account for inventory as selling inventory will take time and hence it cannot be use to pay short term obligations.
The company with > 1 means it can meet its short term obligations and hence should be preferred.
I hope the above ratios will be helpful to filter companies for investment and wealth creation.
Feel free to contact me in case i missed any important ratio or you want me to explain any particular ratio.