A ratio is an expression of quantitative relationship between two figures. According to J. Batty accounting ratio "is used to describes significant relationships which exists between figures shown on balance sheet, in a profit & loss account, in a budgetary control system or in any other part of the accounting organization".
Ratio
analysis is necessary for the company in order to analyze its financial
position, debt position, future prospect, profitability position etc. When you
are start investing in individual stocks, it is necessary to know, how to
calculate and interpret this financial ratios.
Before calculating ratios you have to read
financial statements of the company, like, balance sheet, income statement and
flow. You are not able to calculate ratios without financial statements of the
company.
There are different types of financial ratios
available which can make easy to the stock investors for stock analyze. Ratio analysis
is the part of the fundamental analysis.
Top important financial ratios for every investors should know
So,
let's start with important financial ratios that would be help analyze
companies or stocks.
(i)Return on
equity:
ROE reveals the
returns generated by the core equity capital provided by the shareholders. ROE
represents to all the shareholders, how company utilizes shareholder's
investment money.
ROE=
(Net profit/ shareholder's fund)×100
Interpretation
As
an investor should calculate last 5 years ROE, because you can know, how
company utilizes the shareholders fund? If, ROE is more than 20%, so, its
indicates, company utilizes shareholder's funds properly.
(ii)Return
on capital employed:
ROCE indicates how efficiently the company
utilizes its total capital. Total capital means shareholders fund and borrowing
funds.
ROCE= ( EBIT/Capital employed)
Capital
employed= Assets - short term liabilities
Interpretation
If
companies ROCE is stable and rising continuously, this are favored by
investors. ROCE should be higher than the rate at which the company borrows
funds.
(iii)Debt to
equity ratio:
The debt to equity ratio measures the relationship
between the total amount of debt capital and total amount of shareholders
capital. Debt to equity ratio tell you, does company can repay the long term
liabilities.
D/E=
( total debt/shareholders equity)
Total debt= long term debt + short term debt.
Interpretation
Debt to
equity ratio should be less than 1. If debt is more than equity, you can
assume, the company is risky. If debt is less than equity, so, assume the
company able to repay the loan.
(iv)Current
ratio:
Current ratio
establishes the relationship between current assets and current liabilities of
the firm or company. This ratio expressed that the current assets are
sufficient to pay of current liabilities on time.
Current ratio= (current assets/current liabilities)
Interpretation
Current ratio should be 1.33 to 3. If current ratio less than 1.33, its mean company
can face the problem of repaying the short term liabilities. If current ratio
more than 1.33, its mean company able to pay short term liabilities.
(V)Earnings
per share:
EPS indicates profit allocated to each common share.
EPS=
( Net profit/ No. of outstanding shares)
Interpretation
If EPS increases continuously of the company, generally it's a good sign of the
company. You have to calculate last 5 years EPS.
(vi)Price to
earnings ratio:
P/E ratio is the valuation ratio. It shows how
much the market willing to pay for every rupee of earning. P/E ratio shows,
either company is overvalued or undervalued.
P/E
= ( Current market price/ EPS)
Interpretation
You have to compare peers company. If current market price is undervalued, it's a
good buying decision, If company overvalued. It's a selling decision of the
shares. you will compare company's p/e ratio with industry p/e ratio.
(vii)Inventory
turnover ratio:
It shows the number of times a company has sold
and replaced its inventory in a year.
Inventory turnover ratio= ( Cost of goods sold/closing inventory)
Interpretation
A
low inventory turnover ratio implies weak sales and high inventory. We normally
consider that higher the inventory turnover ratio the better it is.
(viii)Net
profit Margin ratio:
This ratio reveals the overall
profitability of the company after meeting all the direct and indirect
expenses. The percentage of sales that ends up as net income.
Net profit margin=( Net
profit/ Revenue)×100
Interpretation
A higher ratio indicates higher profit and managerial efficiency. A lower ratio
indicates inefficiency of the management and lower profit rate.
(ix)Dividend payout ratio:
The dividend payout ratio measures the percentage of a company's net income that is distributed to shareholders in the form of dividends.
Dividend payout ratio= (Dividend Per Share/Earnings Per share)
Interpretation
The higher ratio indicates the company is reinventing less money back into its business and major portion of profit has been distributed by the company among the shareholders in form of dividend. Higher ratio is favored for the investors.
A lower ratio reflects the company is reinventing more money back into its business and less portion of profit has been distributed by the company among shareholders in form of dividend.
(x)Dividend yield ratio:
The dividend yield is the amount pays to its investors as dividend in comparison with the current market price of the stock.
Dividend yield ratio= (Dividend per share/Market value per share)×100
Interpretation
Higher dividend yield ratio indicates high rate of profit earned by the firm.
(xi)Interest Coverage ratio:
The interest Coverage is a Solvency ratio that measures the ease with which a company can pay its interest liability on the outstanding debt.
Interest Coverage ratio=( EBIT/Finance cost)
Interpretation
A higher ICR indicates the more safety to provides to the debt shareholders. A lower ICR suggests company is not able to meet its interest payments and possiblity of bankruptcy.
(xii)Price to sales ratio:
Price to sales ratio measures the price an investor is willing to pay for company's stock relative to its sales.
Price to sales ratio=( Market value per share/Sales per share)
Interpretation
The price to sales ratio vary drastically by industry and compare companies within same sector.
(xiii)Return on assets ratio:
Return on assets ratio indicates how well a company is performing by comparing the net income it’s generating to the capital it’s invested in assets.
ROA=( Net Inncome/Average Assets)
Interpretation
A positive ratio indicates an upward profit trend and compare companies within same sector.
(xiv)Total assets turnover ratio:
This ratio indicates the company's capability to generate revenue with the given amount of assets.
Total assets turnover ratio=( Operating revenue/Average total assets)
Interpretation
A higher ratio indicates the company is using its assets more efficiently. Lower ratio reflects the company isn't using its assets efficiently. So, higher ratio is favored to the investors.
(xv)Price to book value ratio:
This ratio shows how much equity investors are paying for each rupee in net assets.
P/B ratio=( Market price/Book value per share)
Interpretation
A higher ratio indicates the stock is overvalued and good future growth. A lower ratio indicates the stock is undervalued and future growth is not good.
These are important ratios, that would be helpful for investors of analyze
stocks.
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