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What is financial ratio analysis?
Ratio analysis is used to break up the information on a company’s financial statements. Ratio Analysis for Share Market Investors is very useful to analyze the share and stock of a specific company.
It requires understanding various aspects of the business and valuation.
Financial ratios allow an analyst to promptly analyze a business and its operations as well as the financial situation of a company.
It helps us to reveal valuable information about a company’s profitability, debt repayment ability, operational efficiency, etc. Ratio analysis helps to answer important questions like:
- Is a company’s stock valued appropriately, given its growth prospects and the valuation of its competitors’ stock?
- Is the company earning enough to pay off its debt obligations and able to make profits for shareholders?
- Does the business have enough liquid funds to accomplish its short-term requirements?
- Are the company’s operations efficient enough to optimize profits and avoid capital blockage?
Which are the important ratios of financial analysis for Investors in stocks or share markets?
- Price multiples are used to determine if the company’s stocks are honestly valued vis-a-vis with competitors’ stocks.
- Profitability ratios are used to calculate the profit margins of the company.
- Liquidity ratios assess the working capital arrangement of the company. These are used to make certain if a company has enough liquidity to finance its short-term operations.
- Efficiency ratios are used to guesstimate the operational efficiency of a company.
- Risk (coverage) ratios are used to evaluate a company’s ability to meet its debt obligations. They also give indications about a company’s ability to pay dividends.
Important Ratios for Financial Analysis for share or stock market | ||
Price Multiples | Profitability Ratios | |
Price/Earnings (P/E) | Gross profit margin | |
Price/Forward Earnings (P/FE) | ||
Price / Book Value (P/B | Operating profit margin | |
Price / Sales (P/S) | Net profit margin | |
Price / Total Assets (P/T) | Return on equity (ROE) | |
Price/ Tangible Book Value (P/TBV) | Operating Cash Flow Margin | |
Price /Cash Flow (P/CF) | Return on Asset | |
Price/EBITDA (P/EBITDA) | Return on Invested Capital | |
Price/ Free Cash Flow (P/FCF) | Return on Investment | |
Liquidity Ratios | Efficiency (Activity) Ratios | |
Current ratio | Inventory turnover | |
Quick ratio | Receivables turnover | |
xCash ratio | Payables turnover | |
Days of inventory on hand (DOH) | ||
Risk Ratios | ||
Debt to total capital | Days of sales outstanding (DOH) | |
Debt to equity | ||
Interest coverage ratio | Number of days of payables (DOP) | |
Fixed cost coverage ratio |
Price multiples
These ratios let know you how much you will be implicitly paying for each rupee of the financial statement item if you buy the stock.
Since you want to pay the least amount possible, you should pick stocks with lower price multiples. These are called undervalued stocks.
This means an investor should search and research the undervalued stocks and then decide to invest for that selected and researched stocks.
Price multiples as name implies, it serves a vital role in providing a static and forward glance at a stock’s valuation. The multiples are used to compare present and future (forecasted) valuation multiples of a company with its historical figures and with those of its peers.
Price multiples values are collected from different financial statement items, like sales, cash flows, and total assets.
But earnings (i.e. net profits) and book value are used most commonly.
- Price-to-earnings (P/E):
This is calculated by dividing the stock price by earnings per share (EPS). EPS is calculated as net income divided by the total number of shares.
P/E ratio determines the amount you would have to pay to buy which is a company’s net income. Pick stocks with the lowest P/E because you will be paying the lowest amount for Re 1 of its earnings.
- Price-to-book value (PB): P/E and other multiples calculated using income statement items. These are volatile in nature due to frequent changes in the value of income statement items.
Book value is the total value of a company’s equity as shown on the balance sheet.
There are several things that can not receive from income statements such as face value of its shares, retained earnings, certain reserves, and comprehensive incomes. To get the value of caption data please go directly to the balance sheet.
We will study broadly in a separate section about the above ratios.
Profitability ratios
In general, profitability analysis seeks to investigate business productivity from multiple angles employing a few different scenarios.
Profitability ratios help provide insight into what quantity profit an organization generates and the way that profit relates to other important information about the firm.
Higher profitability ratios are better, as they convey that the business is healthy and sound.
This ratio may be a very crucial ratio for ratio analysis for share market investors.
These ratios include:
Liquidity ratios
Liquidity ratios are the ratios that assess the ability of a company to pay off its short term debt obligations when they fall due.
The liquidity ratios are a consequence of dividing cash and other short term assets by the short term borrowings and current liabilities. It helps with the evaluation of a company’s ability to satisfy its short-term commitments.
They give us an idea about the number of times the short-range debt obligations are covered by the cash and liquid assets. If the value is greater than one that means the short term obligations are fully covered and safe.
Generally, the higher liquidity ratios are an indicative sign of the higher margin of safety that the company posses to pay off its current liabilities.
Simply we can say that greater than one liquid ratio is a great sign of the company is in good financial health and it is less likely to fall into financial crisis.
This ratio is a vital ratio for ratio analysis for share market investors.
Liquidity ratios calculate the ratio between a company’s current assets and its current liabilities. Some of the commonly used liquidity ratios are:
- Current ratio= current assets/ current liabilities
- Quick ratio= (cash + short-term investments + accounts receivable)/ current liabilities
- Cash ratio= (cash + short-term investments)/ current liabilities
The current ratio is the subtraction of all current liabilities from all current assets, while the quick ratio considers only cash from current assets that can be converted to ready liquid the quickest.
The cash ratio is the most stringent as it compares current liabilities with only cash and short-term investments.
The quick ratio also considers accounts receivable, which is the amount a company has to receive from its customers.
The value of liquidity ratios might ideally be near to 1 since this means that the company has sufficient current assets to mitigate its current liabilities.
Efficiency (activity) ratios for ratio analysis for share market investors.
Activity Ratio is the ratio by which we compare the assets of a company to its sales revenue. Asset management ratios indicate how successfully, efficiently, and effectively a company is utilizing its assets to generate its revenues.
It is also known as performance ratios, turnover ratios, and efficiency ratios. These ratios also act as a tunnel of transforming its assets into sales.
Asset management ratios are computed for different assets. Common examples of asset turnover ratios include fixed asset turnover, inventory turnover, accounts receivable turnover ratio, and cash conversion cycle.
These ratios provide important insights into different financial areas of the company and it highlights its strengths and weaknesses.
High asset turnover ratios are enviable because they indicate that the company is utilizing its assets efficiently to produce sales. The higher value of the asset turnover ratios indicates the more sales the company is making from its assets.
The entire cycle of converting inventory to sales and paying suppliers is called the cash conversion cycle.
Operating efficiency is important for companies to make up short cash conversion cycles and generate more cycles in a year. This results in higher revenues.
this conversion of sales quickly helps companies to get quick revenue and avoid borrowing money for operating expenses.
Operating efficiency is calculated by either calculating the length of a company’s cash conversion cycle or the number of cycles it completes in a year.
You will need to calculate the following if you choose the first method:
- Inventory turnover= Cost of goods sold/ average inventory*
- Receivables turnover= Sales revenue/ average accounts receivable*
- Payables turnover= (Cost of goods sold + opening inventory balance – closing inventory balance)/ average accounts payable*
- Working Capital Turnover = Net Annual Sales / Average Working Capital
These ratios are helping hand to check the conversion efficiency at various stages of the cash conversion cycle.
A high value for these ratios means higher efficiency.
Income statement or balance sheet is the directory of the financial statement of a company from where figures can be picked up by the analysts. ‘Average’ means the average of the beginning and ending values of these items for the year.
Another method is for calculating the number of days the company takes to complete each step of the cash conversion cycle.
The following formulas are used for this:
- Days of inventory on hand (DOH) = 365/ inventory turnover ratio.
- Days of sales outstanding (DSO)= 365/ receivables turnover ratio.
- The number of days of payables (DOP)= 365/ payables turnover ratio.
With the help of a small number for these ratios indicates high process efficiency except DOP.
Finally, you will need to calculate the number of days taken to complete the entire cycle. Use the following equation for this:
Cash conversion cycle: DOH + DSO – DOP
Companies with highly efficient processes take the fewest days to complete the cash conversion cycle.
Risk ratios for ratio analysis for share market investors.
Companies have two kinds of capital – equity and debt. Investment is done by the shareholders is equity. when a firm takes loan from any bank or financial institution is debt.
Shareholders should seriously monitor a company’s debt because high debt increases the chances of default.
This ratio is a very important ratio for ratio analysis for share market investors.
Risk ratios calculate the proportion of debt in a company’s capital structure and assess the company’s ability to repay its debt obligations. There are three important financial ratios that fall under this category:
- Debt to total capital= total debt/ (total equity + total debt)
- Debt to equity= total debt/ total equity
- Interest coverage ratio= EBIT/ interest expense for the period
Debt to total capital and debt to equity calculate the extent of a company’s indebtedness. High values for these ratios indicate a high risk for investors.
With the help of interest coverage ratio investor estimates a company’s ability to repay its debt.
A high-interest coverage ratio is good for the company to generate enough earnings before interest and taxes to repay its debt.
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