Financial ratios

Financial ratios

There are various kinds of financial ratios which are calculated and used by the investors and analysts. These financial ratios are calculated from the information in the financial statements of the company and are used in the fundamental analysis of the company. The financial ratios are compared with the financial ratios of the last few years of the same company (intra-firm comparison) and with the financial ratios of other companies in the same industry (inter-firm comparison).

Financial ratios can be classified into the following broad categories:-

– Profit margin ratios
– Turnover ratios
– Solvency ratios
– Liquidity ratios
– Investment valuation ratios

Profit Margin Ratios:-

Profit margin ratios indicate how efficiently the company is able to generate profit from its operations. Following are the various types of profit margin ratios:-

Gross Margin Ratio:-

Gross margin ratio is also called as gross profit ratio. Gross margin ratio compares the gross profit of the company to the net sales. Gross profit is calculated by subtracting the cost of goods sold from the net sales. Cost of goods sold indicates all the direct costs incurred by the company on all the products sold. Gross margin ratio should be high enough to cover the indirect costs, taxes, interest and depreciation expenses.
Formula for calculating gross margin ratio:-
Gross margin ratio = gross profit ÷ net sales × 100

Net Margin Ratio:-

Net margin ratio is also called as net profit ratio. Net margin ratio compares the net profit of the company to the net sales. Net profit is the profit earned by the company after subtracting all the expenses incurred by the company. A company should have a high net margin ratio which is possible if all the concerned expenses incurred by the company are kept in control.
Formula for calculating net margin ratio:-
Net margin ratio = net profit ÷ net sales × 100

Operating Margin Ratio:-

Operating margin ratio is also called as operating profit ratio or EBITDA ratio. Operating margin ratio compares the operating profit of the company to the net sales. Operating profit is calculated by subtracting the cost of goods sold and operating expenses from the net sales. Operating expenses are the indirect costs of the company. Operating margin ratio should be high enough to cover taxes, interest, depreciation and amortization expenses.
Formula for calculating operating margin ratio:-
Operating margin ratio = operating profit ÷ net sales × 100

Return On Equity Ratio:-

Return on equity ratio shows how much profit the company generates with the money invested by both the preference and equity shareholders. It measures how efficiently the company generates profit for every unit of shareholders equity.
Formula for calculating return on equity ratio:-
Return on equity ratio = net profit ÷ average shareholders equity × 100
Shareholders equity = equity share capital + preference share capital + reserves and surplus
Average shareholders equity = shareholders equity (current year) + shareholders equity (previous year) ÷ 2

Return On Common Equity Ratio:-

Return on common equity ratio shows how much profit the company generates with the money invested by equity shareholders i.e common shareholders. It measures how efficiently the company generates profit for every unit of common shareholders equity.
Formula for calculating return on common equity ratio:-
Return on common equity ratio = net profit – preference dividend ÷ average common shareholders equity × 100
Common shareholders equity = equity share capital + reserves and surplus
Average common shareholders equity = common shareholders equity (current year) + common shareholders equity (previous year) ÷ 2

Return On Capital Employed Ratio:-

Return on capital employed shows how much profit the company generates with the total capital employed by the company. It measures how efficiently the company generates profit for every unit of capital invested.
Formula for calculating return on capital employed ratio:-
Return on capital employed ratio = earnings before interest and tax ÷ average capital employed × 100
Capital employed = equity share capital + preference share capital + reserves and surplus + long-term debt
Average capital employed = capital employed (current year) + capital employed (previous year) ÷ 2

Return On Assets Ratio:-

Return on assets ratio shows how much profit the company generates by using its assets. It measures how efficiently the company generates profit for every unit of asset the company has.
Formula for calculating return on assets ratio:-
Return on assets ratio = net profit ÷ average total assets × 100
Total assets = long-term assets + current assets
Average total assets = total assets (current year) + total assets (previous year) ÷ 2

Turnover Ratios:-

Turnover ratios are also called as activity ratios. Turnover ratios indicate how efficiently the company runs its various operations. Following are the various types of turnover ratios:-

Accounts Receivable Turnover ratio:-

Accounts receivable turnover ratio is also called as debtors turnover ratio. Accounts receivable turnover ratio shows how efficiently the company issues credit to its customers and recovers it . It indicates how many times the company collects its average accounts receivable during a period. A high accounts receivable turnover ratio is considered as good.
Formula for calculating accounts receivable turnover ratio:-
Accounts receivable turnover ratio = credit sales ÷ average accounts receivables
accounts receivables = debtors
average accounts receivables = debtors (current year) + debtors (previous year) ÷ 2

A variant of the accounts receivable turnover ratio called as average collection period is also calculated. Average collection period indicates the number of days, on an average, the company takes to collect its accounts receivable. It measures the average number of days the company requires to convert its accounts receivables into cash. A lower average collection period is considered as a good sign as it implies that the company is taking less time to recover credit given to the customers thus ensuring liquidity.
Formula for calculating average collection period:-
Average collection period = 365 ÷ accounts receivable turnover ratio

Accounts Payable Turnover Ratio:-

Accounts payable turnover ratio is also called as creditors turnover ratio. Accounts payable turnover ratio shows the rate at which the company pays its suppliers for the credit purchases made from them. It indicates how many times the company pays its average accounts payable during a period. A low accounts payable turnover ratio is considered as good.
Formula for calculating accounts payable turnover ratio:-
Accounts payable turnover ratio = credit purchases ÷ average
accounts payables

Accounts payables = creditors
Average accounts payables = creditors (current year) + creditors (previous year) ÷ 2

A variant of the accounts payable turnover ratio called as average payment period is also calculated. Average payment period indicates the number of days, on an average, the company takes to pay its accounts payable. It measures the average number of days the company requires to pay the suppliers for the credit purchases made from them. A higher average payment period is considered as a good sign as it implies that the company can pay its credit bills after a longer period of time thus ensuring liquidity.
Formula for calculating average payment period:-
Average payment period = 365 ÷ accounts payable turnover ratio

Inventory Turnover Ratio:-

Inventory turnover ratio is also called as stock turnover ratio. Inventory turnover ratio shows how efficiently the company turns its inventory into sales. It indicates how many times, on an average, the company sold and replaced its inventory during a period. A high inventory turnover ratio is considered as good.
Formula for calculating inventory turnover ratio:-
Inventory turnover ratio = cost of goods sold ÷ average inventory
Average inventory = inventory (Current year) + inventory (previous year) ÷ 2

A variant of the inventory turnover ratio called as inventory turnover days or days inventory outstanding is also calculated. Inventory turnover days indicate the number of days, on an average, the company takes to turn its inventory into sales. If the inventory turnover days are less, it is considered as a good sign as it implies that the sales of the company are rapid and not much of the company’s capital is tied up in inventory.
Formula for calculating inventory turnover days:-
Inventory turnover days = 365 ÷ inventory turnover ratio

Assets Turnover Ratio:-

Assets turnover ratio shows how efficiently the company uses its assets to generate sales. A high assets turnover ratio is considered as good which shows that the company is efficiently using its assets to generate sales.
Formula for calculating assets turnover ratio:-
Assets turnover ratio = net sales ÷ average total assets

Total assets = long-term assets + current assets
Average total assets = total assets (current year) + total assets (previous year) ÷ 2

Solvency Ratios:-

Solvency ratios are also called as leverage ratios. Solvency ratios indicate the company’s capacity to meet its debt obligations especially long-term debt obligations. They determine the chances of company’s survival in the long run. There are two types of solvency ratios which are as under:-

Debt-To-Equity Ratio:-

Debt-to-equity-ratio is also called as financial leverage ratio. Debt-to-equity ratio indicates the relative proportion of borrowed capital i.e. debt and owned capital i.e. shareholder’s equity in the capital structure of the company. A low debt-to-equity ratio is considered as good indicating that the company has less amount of debt in its capital structure and hence more stable. A high debt-to-equity ratio is considered as bad indicating that the company has higher amount of debt in its capital structure and hence less stable. Debt has to be repaid so there are more chances of the company becoming insolvent if it is not able to repay the high amount of debt it has taken.
Formula for calculating debt-to-equity ratio:-
Debt-to-equity ratio = total debt ÷ total equity

Total debt = long-term debt + short-term debt
Total equity = preference share capital + equity share capital + reserves and surplus
If the preference shares are redeemable then they are taken as debt.

Interest Coverage Ratio:-

Interest coverage ratio is also called as times interest earned ratio. Interest coverage ratio determines how easily the company can pay interest on its outstanding debt. It shows how well the earnings of the company cover the interest costs. A high interest coverage ratio is considered as good indicating that the company is earning sufficiently to easily meet its interest expenses. Whereas a low interest coverage ratio indicates that the company is not earning enough to easily meet its interest expenses and is in danger of becoming insolvent if the earnings become even less.
Formula for calculating interest coverage ratio:-
Interest coverage ratio = earnings before interest and tax ÷ interest expense

Liquidity Ratios:-

Liquidity ratios indicate the company’s capacity to meet its short-term debt obligations. They test the short-term solvency of the company. There are three types of liquidity ratios which are as under:-

Current Ratio:-

Current ratio is also called as working capital ratio. Current ratio tests the liquidity of the company by finding out the proportion of current assets available to pay the current liabilities. Higher the current ratio, the better it is. Higher current ratio indicates that the company has higher amount of current assets compared to current liabilities and can easily pay off the current liabilities from the current assets. Whereas a lower current ratio is not good as it indicates that the company has lower amount of current assets compared to current liabilities and the company may struggle to pay off the current liabilities from the current assets.
Formula for calculating current ratio:-
Current ratio = current assets ÷ current liabilities

Quick Ratio:-

Quick ratio is also called as acid test ratio. Quick ratio refines the current ratio by removing inventory from the current assets as inventory cannot be liquidated easily. Quick ratio is a better indicator of liquidity than current ratio.
Formula for calculating quick ratio:-
Quick ratio = current assets – inventory ÷ current liabilities

Cash Ratio:-

Cash ratio refines the quick ratio by removing any receivables from the current assets. Cash ratio considers only highly liquid current assets and cash itself.
Formula for calculating cash ratio:-
Cash ratio = cash and cash equivalents + marketable securities ÷ current liabilities

Investment Valuation Ratios:-

Investment valuation ratios are also called as market valuation ratios. Investment valuation ratios are used by investors and analysts in the relative valuation of companies. Following are the various types of investment valuation ratios:-

Price/Earnings Ratio:-

Price/earning ratio or P/E ratio is also called as price/earning multiple or P/E multiple. price/earnings ratio tells how much the investors are willing to pay for the company’s earnings. It tells the price that the investors are ready to pay for each unit of profit earned by the company.
 Higher the price/earnings ratio, the more investors are willing to pay for each unit of company’s profit as they are expecting higher earnings growth of the company in future and so are paying more for today’s earnings. Growth investors view high price/earnings ratio stocks as an attractive investment opportunity. while the value investors view high price/earnings ratio stocks as overvalued and hence not good for investment.
 Lower the price/earnings ratio, the less investors are willing to pay for each unit of company’s profit as they do not expect much earnings growth of the company in future. Value investors view low price/earnings ratio stocks as an attractive investment opportunity as they consider stocks with low price/earnings ratios to be currently undervalued and will perform better in future. While the growth investors view low price/earnings ratio stocks as not good for investment as they do not expect the company’s earnings to grow much in future.
Formula for calculating price/earnings ratio:-
Price/earnings ratio = market price per share ÷ earnings per share
Earnings per share = net profit – preference dividend ÷ number of equity shares outstanding

Price/Earnings Growth Ratio:-

Price/earnings growth ratio or PEG ratio refines the price/earnings ratio by including the company’s estimated earnings growth. It compares the stock’s price/earnings ratio with its estimated earnings per share growth. Price/earnings growth ratio is used along with the price/earning ratio. Price/earnings growth ratio can offer a suggestion to the growth investors as to whether a stock’s high price/earnings ratio is a refection of promising earnings growth prospects of the company or excessive high price of the stock. Price/earnings growth ratio can also offer a suggestion to the value investors as to whether a stock’s low price/earnings ratio is because of under-valuation of the stock or poor earnings growth prospects of the company.
 Price/earnings growth ratio varies from person to person as expected earnings per share growth rate is an estimate.
Formula for calculating price/earnings growth ratio:-
Price/earnings growth ratio = price/earnings ratio ÷ expected
earnings per share growth

Price/Book Ratio:-

Price/book ratio or P/B ratio is used to compare the company’s book value to its current market price. A higher price/book ratio indicates that the stock is currently over-valued and not good for investment. While a lower price/book ratio indicates that the stock is currently under-valued and good for investment. However a lower price/book value ratio might also indicate that something is wrong with the company. Price/book ratio is generally used for companies with more liquid assets such as banks and financial companies.
Formula for calculating price/book ratio:-
Price/book ratio = market price per share ÷ book value per share

Book value per share = equity share capital + reserves and surplus – revaluation reserves ÷ number of equity shares outstanding

Enterprise value/EBITDA Ratio:-

Enterprise value/EBITDA ratio or EV/EBITDA ratio is also called as enterprise multiple. Enterprise value/EBITDA ratio compares the enterprise value with earnings before interest, tax, depreciation and amortization (EBITDA). If the enterprise value/EBITDA ratio is lower, it is considered that the company’s stock is under-valued and hence good for investment and the company is a good takeover candidate from the acquirer’s perspective. While a higher enterprise value/EBITDA ratio means that the company’s stock is over-valued and hence not good for investment and the company is not a good takeover candidate from the acquirer’s perspective.
Formula for calculating enterprise value/EBITDA ratio:-
Enterprise value/EBITDA ratio = enterprise value ÷ EBITD
A
Enterprise value = market value of equity + market value of debt – cash

Dividend Yield Ratio:-

Dividend yield ratio shows the relationship between dividend per share and the market price per share. It indicates how much a company pays out in dividend each year in relation to the market price of its shares. Dividend yield ratio is useful for the investors who are more interested in the dividend income than capital gains. Generally, higher the dividend yield ratio, the better it is. But sometimes a high dividend yield ratio may be because of decrease in the market price of the company’s stock recently because of poor financial performance and the company may have to reduce the amount of dividend in future.
Formula for calculating dividend yield ratio:-
Dividend yield ratio = annual dividend per share ÷ market price per share × 100

Dividend Payout Ratio:-

Dividend payout ratio shows the portion of net profit of the company that is paid to the shareholders in the form of dividends during the year. In other words, dividend payout ratio shows the portion of net profit, the company gives as dividend to the shareholders and the portion of net profit, the company retains in the business for its operations. A high dividend payout ratio means that the company is paying a large portion of the net profit as dividend to its shareholders and retaining less portion of net profit in the business. While a low dividend payout ratio means the company is doing the opposite. A high dividend payout ratio is preferable to the investors who are more interested in earning regular dividend income instead of capital gains.
Formula for calculating dividend payout ratio:-
Dividend payout ratio = annual dividend per share ÷ earnings per share × 100
                                                                  Or
Dividend payout ratio = total dividend ÷ net profit × 100

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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