Financial ratios compare numbers within a company’s balance sheet and income statement to understand its performance and judge its potential. Investors conduct ratio analysis as a part of the decision-making process before investing in a company’s shares.
There are four categories of financial ratios — profitability, liquidity, solvency and valuation. Read on to find out how to analyse financial statements using ratio analysis. This article will also touch upon how to interpret financial ratios analysis.
Profitability ratios
A company’s profit, i.e. revenue minus expenses, is clearly stated in its income statement. However, just because a company registered a profit in a given quarter, it does not necessarily make the company profitable. A company’s profitability depends on how efficient it is at utilising available resources to make its profits.
High revenues alone do not translate to good dividends for an investor. As such, investors consider various profitability ratios when considering a potential investment, some of which are:
Net profit margin helps gauge a company’s profit as a percentage of its revenue and is calculated as-
Net Profit Margin= Net Income/Reported Revenue
Net income is a company’s revenues minus expenses and taxes. If a company has higher profit margins versus its competitors, you can surmise that it will be better off during hard times. It also indicates higher management efficiency.
Another ratio you can use to gauge a company’s business is the return on assets or ROA, which reveals a company’s profitability relative to available resources/assets. As such, a higher ROA would indicate more efficient operations. The ratio is as follows:
ROA= Total Assets/Net Income
Liquidity ratio
Liquidity ratios reveal how fast a company can repay existing debts or raise money to buy new assets over the next year.
The current ratio is used often as a way to evaluate the liquidity position of a firm. But how to analyze the current ratio? The ratio signifies how many times over the assets – cash or short-term investments to be utilized over the financial year – will cover its current liabilities – debt due for repayment over the next 12 months.
Current Ratio=Current Assets/Current Liabilities
Solvency ratio
These ratios measure a company’s ability to deal with debt obligations over the long term. The often-used Debt to Equity Ratio = Total Liabilities/Total Shareholder’s Equity determines how much of a company’s operations are financed by debt and whether shareholder equity can cover outstanding debt obligations in case of adverse business conditions.
So, how to analyze the debt to equity ratio before investing in a company’s stock? A high debt to equity ratio means a large part of the company’s business is debt-financed, which may make some shareholder’s uncomfortable. In case of a downturn, the resultant income generated may not be commensurate with the cost of debt undertaken, proving to be an unfavourable business decision that could negatively impact share value.
Valuation ratio
These ratios help determine whether a particular company will make for a good investment. Usually, a lower ratio indicates a better investment bet.
A popular valuation ratio is the price-to-earnings (P/E) ratio that compares stock price to earnings per share.
P/E= Market Value Per Share/Earnings Per Share
A higher P/E ratio usually suggests the stock to buy may be overpriced.
However, the P/E ratio of companies varies significantly across industries. As such, one should compare the P/E ratio of a particular company with industry competitors to make sensible decisions.
Taking the right stock market investment decision
The above are a few ways on how to analyze the ratios of a company before investing in its stock, definitely not an exhaustive list.
Financial ratios can help make comparisons between companies belonging to the same industry. They can also help gauge a company’s present performance in comparison with its earlier performance.
However, when using ratios to evaluate a company, it is necessary to understand the context within which the businesses are functioning to make sensible mutual fund and stock investment decisions.
