Important Financial Ratios: Financial Statement
Financial Ratio can be a horror until it is understood. It has the possibility of opening a new world of value investing. It’s important to test stocks on various standards and understanding their details will bring interpretations that can completely change the way one look about a company.
These numerical derivations and formula can change your perception of how you look at the investment goals and measures. It’s actually like adding a mathematical spice to your investment decision mix.
These financial ratios are majorly categorized into Valuation, Profitability, Liquidity, Efficiency and Debt pointers. In this topic we will discuss a few of the must-know ratios which will enable you to efficiently maneuver in the sea of stock market, and consider the right investment plan for you and your financial risk and return package.
Important Financial Ratios which make Stock Investing Easy
Here are some basic but very crucial financial ratios that every investor must know, and these are quite simple to understand. So, let’s learn about the useful financial ratios one by one.
Liquidity Ratios
1. Current Ratio:
This ratio serves as a proof of a corporation’s ability to cover immediate obligations such as current debt or other payables, with resources at hand. It’s calculated as the value of current assets to current liabilities. It is also referred as the Working Capital Ratio.
Current Ratio = Current Assets / Current Liabilities
2. Quick Ratio:
It helps investors to comprehend the extent to which the current or short term liabilities can be paid off with the liquid assets at hand minus the inventory, as it assumes selling the inventory might take more time than available. It is also known as Acid Test ratio. Similar to the current ratio, it is considered a much more reliable financial number to measure financial strength.
Quick Ratio = (Current Assets – Inventories)/ Current Liabilities
Profitability Ratios
3. Gross Profit Margin:
It is used to calculate the financial well-being of a company/organization by revealing the actual profit available after removing the cost of goods sold. It tells a trader how much margin is left before deducting expenses related to marketing, administration, payroll and so on. This analysis can be employed to compare business models and review the ones that have an edge in the industry and is worth the investment.
Gross Margin Ratio = Gross Profit / Net Sales
4. Operating Margin Ratio:
It is the overall profit a business produces from its operations before other elements such as dividends, income taxes, etc. that needs to be paid divided by the net sales. This measures how effective a company’ profit generation capacity excluding the effects of taxes and other related financial decisions.
Operating Margin Ratio = Operating Income / Net Sales
5. Net Profit Margin:
A profitability ratio used to determine the overall efficiency of a company. A higher net profit margin ratio describes how efficiently the business is converting its revenue into profits. This is represented in percentage.
Net Profit Margin = Net Profit / Net Sales
where, Net Profit = Net Operating Profit Before Interest and Tax
Net Sales = Cash Sales + Credit Sales
6. Return on Equity Ratio (ROE):
It is one of the most applied financial ratio to analyse the profit earned by a business from its stockholders’ investments or shareholder equity. Return on Equity is a valuable indicator to understand how excellent the management is at utilising these funds to develop and build the company’s operation.
Return on Equity Ratio = Net Income/Shareholder’s Equity
Important Financial Ratios of a Financial StatementLeverage Financial Ratios or Debt Ratios
7. Debt to Equity Ratio:
It helps to evaluate the capacity of shareholder equity in covering debts during a downward spiral. It’s readily used in corporate finance to realize a company’s actual leverage and the risks to shareholders.
Debt to Equity Ratio = Total Liabilities / Shareholders Equity
8. Interest Coverage Ratios:
In this age of credit, many enterprises are run on debt and the investor has the responsibility to weigh the ability of the venture to cover the interest payments incurred on its debt, to measure its growth prospects.
Interest Coverage Ratio = Operating Income (or EBIT) / Interest Expenses
Important Financial Ratios of a Financial StatementEfficiency Ratios
9. Asset Turnover Ratio:
It estimates how well the firm utilizes its assets to generate sales. A low asset turnover ratio means the assets are not being used cost-effectively to create sales and could be a concern for investors.
Asset Turnover Ratio = Net Sales / Average Total Assets
Other efficiency ratios include:10. Inventory turnover ratio = Cost of goods sold / Average inventory
11. Receivables turnover ratio = Net credit sales / Average accounts receivable
Price Ratios or Market Value Ratios
12. Price-to- Earnings Ratio or P/E Ratio:
It is regarded to ascertain if a stock is over valued or under valued. It helps investors find growth companies to achieve a sustainable return on their investment, while understanding if they are paying a fair price for owning it.
P/E Ratio = Price per Share/ Earnings per Share
13. Price-to-Book Value Ratio:
It’s a comparison of the market price of the stock to its book value or net assets. The book value is usually recorded in the disclosed financial statements, while the share price is how the market values the company. There is a possibility that the stock might be overvalued or undervalued, and this helps to evaluate the perception.
P/B Ratio = Price per Share / Book Value per Share
14. Dividend Payout Ratio
It is the percentage of profit a company distributes in the form of dividend to its shareholders.
Dividend Payout Ratio = Dividend / Net Income
15. Earning Per Share or EPS:
EPS is a key metric of a company’s earnings. When you divide the net profit generated by the number of shares. A continuous growth in EPS shows a sign of good growth oriented company/enterprise.
Earnings per share Ratio = Net Earnings / Total Shares Outstanding
Important Financial Ratios of a Financial StatementConclusion
It’s all about a minor effort to understand these measures and implement it wisely to grow your money in a better way with improved results. Once equipped, an investor can attain heights of clarity which puts one on the path to success in investing.
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