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What Is Financial Ratio? What Stock Investors Should Know

Financial Ratio
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Financial statements by themselves do not reveal anything. They provide raw data that gets converted into useful information. Statements get analyzed to understand the company’s performance for an investment decision. Ratios help us with the decision-making process. Ratios involve dividing two elements from the financial statements and interpreting their relationship to convey some meaning to decide.

Ratios are classified broadly, affecting profitability, return leverage, liquidity, efficiency, and valuations. Some ratios that investors can learn through the best Stock Market app are:

 

Profitability Ratios

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These convey how profitably the company’s operations are conducted at operating and net profit levels. It includes the following ratios expressed in percentage

  • Gross Profit Margin = (Sales – Cost of goods sold) / Sales: This conveys the profit margin at the gross level.
  • Operating Profit Margin = Operating profit / Sales: Operating profit margin specifies a company’s profit margin before interest payments and taxes.
  • Net Profit Margin = Net profit / Total revenue (Sales + other income): Net profit margin shows net margins. A high net profit margin is a good indication of an efficient business.

 

Return Ratios

They are used to understand how much profit the shareholders’ fund generates; they earn as a percent of the net profit. It also measures how efficiently the assets are used to generate revenue:

  • Return on Equity (RoE) = Net profit/ Shareholders fund: The shareholder’s fund is also the company’s net worth, which is the sum of equity capital and free reserves.
  • Return on Assets (RoA) = Net income / Total assets

 

Leverage Ratios

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Business gets done not only with owners’ capital but also with borrowed funds. It measures the ability of the company to remain solvent as it measures the debt proportion in the company’s capital structure.

  • Debt to equity = Long term borrowings/shareholder’s fund (Net worth): This ratio shows the dependence of external funds internally and compares a company’s overall debt to its shareholder’s funds.
  • Interest coverage ratio = Earnings before interest and tax (EBIT) / Interest: The expense measures the minimum profit or cash flow to be generated at the operating level to cover the interest costs.

 

Liquidity Ratios

They help understand the capacity of a company to pay off the immediate or short-term liabilities. While there are no benchmarks, a liquidity ratio of two denotes a comfortable liquidity position.

  • Current ratio= Current assets/Current liabilities
  • Quick ratio= (Current assets – Inventory)/Current liabilities: The acid test ratio excludes inventory from current assets as inventory longer time gets converted into cash.

 

Efficiency Ratios

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They are used to measure how efficiently the company’s assets are used to generate sales or revenue.

  • Assets turnover ratio= Net sales/Total assets: Measures the revenue generated out of total assets employed. The higher the ratio better it is.
  • Inventory turnover = Net sales/Inventory: Measures how efficiently the company manages inventory and indicates how fast the inventory gets replenished.
  • Receivable turnover = Net sales / Accounts receivable: Measures how quickly the sales are converted into cash.
  • Receivable’s days ratio= 365/Receivable’s turnover: This ratio measures the number of days it takes for collection.

 

Valuation Ratios

These convey what value the market is assigning to the stock concerning price. Price and value are two different things. Value is perception, while price is the function of demand and supply. Let’s peep into a few valuation ratios.

  • Price to earnings ratio (PE)- Current market price (CMP)/Earnings per share (EPS): This is the most popular ratio where the market price gets divided by the EPS to understand what value is the market assigning to the current or future earnings of the company. If one compares this ratio within the peer group, one can see the relative undervaluation or overvaluation.
  • Dividend yield ratio- Dividend yield = Dividend per share/ CMP: A company with a good track record of paying dividends is perceived as a stable company with a sustainable profit. The higher the ratio better it is.
  • Price to cash flow = CMP / Operating cash flow per share: It is the most reliable ratio. It measures what price the market is assigning to the cash-generating capacity of the company from operations.

Download the best Share Market app and learn about these ratios, and accordingly implement them and invest in the market.

Disclaimer – ICICI Securities Ltd. ( I-Sec). The registered office of I-Sec is at ICICI Securities Ltd. – ICICI Venture House, Appasaheb Marathe Marg, Prabhadevi, Mumbai – 400 025, India, Tel No: 022 – 6807 7100. The contents herein above shall not be considered as an invitation or persuasion to trade or invest. I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein above are solely for informational purposes and may not be used or considered as an offer document or solicitation of an offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investments in the securities market are subject to market risks, read all the related documents carefully before investing. The contents herein mentioned are solely for informational and educational purposes.

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Praneet Samaiya
the authorPraneet Samaiya
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