If you have been investing for a while, you may have come across different financial ratios. As an investor, it is useful to be aware of certain important fundamental ratios. These ratios reveal insights into the overall performance of a company. They are also handy for comparing a company with its peers.
Ratios are typically used for determining liquidity, solvency, profitability, efficiency, and valuation.
1. Liquidity ratios
Investors can scrutinize the ability of a company to easily meet its short-term debt obligations and liquidity needs by using the liquidity ratios.
Different types of liquidity ratios are:
The current ratio helps an investor to assess whether a company can clear its short-term liabilities (usually due within a year) with its current assets.
How does it help: It is used to compare companies in the same industry. It educates investors about the company’s short-term future and fund requirements. A current ratio higher than one would indicate the organization’s higher capability of repaying its short-term debt obligation. A healthy current ratio is more than 1 with 1.5-2 being an ideal range.
The quick ratio is used to determine the capability of the company to pay off its ultra-short-term and immediate liabilities with its most liquid assets. Examples of liquid assets include cash, mutual fund investments, etc. The quick ratio does not include inventory in the calculation as it may not be easy to liquidate. It is also called the acid test ratio.
How does it help: Using the quick ratio helps managers, lenders and investors assess the company’s liquidity and spot cash flow issues early. A quick ratio of 1:1 is preferable.
2. Solvency ratios – like Debt-to-equity ratio
Solvency ratios are used to assess whether a company is financially stable, solvent, and capable of clearing its medium to long-term debt obligations.
Interest coverage ratio
The interest coverage ratio is used to determine the solvency of a company to service its debt.
How does it help: It helps you avoid investing in companies that are on the verge of bankruptcy.
Debt to equity ratio
The assets are funded either by own funds (i.e. equity) or owed funds (i.e. debt). As a shareholder, it is very important to know the structure of the source of the funds in the company. A highly leveraged company may not have a sustainable future because of mounting debts on the balance sheet.
How does it help: A very high ratio suggests that the company has borrowed more capital to fund the business as compared to the owned funds put in the business. Conversely, a low debt-to-equity ratio means that the company is borrowing less from the market and using more of its cash flow from assets and earnings. The debt to equity ratio helps you compare different companies in the same industry to understand the competitive landscape. Across industries, a ratio of 2 is preferable.
3. Profitability ratios
The profitability ratio helps in measuring the financial performance of a company. These ratios are generally compared with competitors to understand how well the business is doing operationally.
Gross profit ratio
The gross profit ratio is calculated to determine the operational ability of the company to generate profits. It considers only the cost of goods sold and the revenue for the relevant period.
A percentage GP is then compared to best-in-class companies in the same industry to do an external benchmarking and identify areas of improvement for the company.
How does it help: It helps to evaluate how efficiently the company can generate profits from the sales of its products or services by managing its resources. Gross profit ratio is aggressively used in industries such as FMCG and IT. It is important to compare the margins across companies in the same industry. Higher the margins, better the company.
Net profit ratio
Net profit is as important as gross margins, if not more. The company may be profitable on a per-unit basis (i.e. profitable per unit sold), but it may not be profitable based on the bottom line.
Surprised? Well, it is because there could be multiple fixed expenses the company incurs.
How does it help: Companies across industries widely use PAT. It helps you understand the financial value of a company you wish to invest in. However, it is important to compare the net profit ratio of companies in the same industry.
Return on capital employed (ROCE)
The ROCE ratio is widely used in the financial world. ROCE is used to determine the profitability of the company against the capital invested. It is used to find out the amount of profit earned on each rupee invested in the company.
The numerator is EBIT because it considers the returns for both the equity and debt holders.
How does it help: It can help investors understand how well a company is generating profits from its capital. You can invest in a company that has high ROCE as compared to its peers (i.e. highest profits on the amount invested)
4. Efficiency ratios
Efficiency ratios are used to measure how effectively a company uses its assets and liabilities to generate revenue. Efficiency ratios are generally mixed ratios where one element is taken from the income statement while the other element may be taken from the balance sheet.
Asset turnover ratio
The asset turnover ratio is used to compare net sales with average total assets to analyze a company’s ability to generate sales from its assets.
How does it help: It helps you understand how asset-heavy industries like telecom, metals, industrials, etc. use their fixed assets to generate revenue.
Inventory turnover ratio
It is used to evaluate companies that follow an inventory-led model. It helps investors to know if the inventory is fast-moving or slow-moving. It measures the efficiency of inventory management. It is generally used to evaluate FMCG companies where there are high inventories and multiple product variants.
How does it help: The inventory turnover ratio helps investors determine the rate at which the company converts its inventory into sales. A higher inventory turnover ratio would mean strong sales (and therefore demand) or huge discounts.
5. Valuation ratio
A valuation ratio enables investors to figure out whether a company’s stock is overvalued, fairly valued, or undervalued. It helps to understand the relationship between the market value of a company or its equity and some fundamental financial metric such as earnings.
Price to Earnings ratio (PE ratio)
The price to earnings ratio is used to calculate and compare the market valuation of the company against the industry peers to know if the share is overpriced or underpriced. P/E shows what the market is willing to pay today for a stock based on its past or future earnings. This ratio is widely used and easy to calculate.
How does it help: This ratio helps investors know which stock to invest in based on the P/E. A very high PE stock is categorized as overvalued and low PE is considered undervalued compared to its industry competitors.
EV to EBIDTA
EV/EBITDA ratio is used to understand the total enterprise value compared to EBIDTA i.e. earnings before interest, taxes, depreciation, and amortization. Primarily, this ratio explains how many multiples of EBITDA the overall value of the company is i.e. if an investor buys the entire company, what is the amount of money that he has to pay.
How does it help: It helps investors evaluate if the company is in a high-growth phase, have high debt on their balance sheets, or have longer gestation periods. Therefore, it may be used to value companies in emerging sectors such as FinTech or E-commerce, other sectors such as cement, telecommunication, or steel with high gestation and debt levels. A lower EV to EBIDTA makes a company’s valuation attractive.
Ratios are vital tools that let investors to make the right investment decisions. But remember, use ratios properly while evaluating companies so investing becomes a breeze.