If you’re a long-term investor, then it’s important for you to examine various kinds of corporate financial statements, such as income statements, balance sheets, and cash flow statements, when making investment decisions. But what exactly do you do with all that data, and how do you make it more digestible and actionable? That’s where financial ratios come in.
Financial ratios, also known as accounting ratios, help make sense of the data given in a company’s financial statements. They are crucial financial analysis tools that can help you determine whether you should invest in a particular company or not. They take the numerical values indicated in financial statements and provide meaningful information about a company’s overall financial health, its performance relative to its industry as a whole, its long-term viability, and more.
Important financial ratios to use when evaluating investments
While there are dozens of financial ratios that you can use for investment analysis, here are some of the most useful ones that you should know about.
- Earnings Per Share (EPS)
The EPS is a financial analysis ratio that indicates how much of a company’s profit is attributed to each of its outstanding shares, i.e., how much profit a shareholder would make for every share of the company they own. The EPS is the company’s net profit divided by its total outstanding shares. This ratio helps you determine the value you will receive by investing in a company: the higher the EPS, the better.
- Price-to-Earnings (P/E) ratio
This is an important ratio to assess whether a stock is overvalued or undervalued. The P/E ratio is calculated by dividing the market price per share by the EPS to determine how much investors are willing to pay for each rupee of earnings generated by the company. For instance, if the current share price of a stock is ₹1,500 and its EPS is ₹80, then the P/E of this company is obtained by dividing the former by the latter, yielding 18.75. This means that investors are willing to pay more than 18 times the company’s earnings for holding its stock. The P/E ratio is primarily useful for valuation and comparative analysis.
- Debt-to-equity ratio
This ratio helps assess a company’s financial risk and leverage. It indicates the degree to which its operations are being financed through debt over its own resources (known as shareholders’ equity). A high debt-to-equity ratio means that the company is relying more on debt, which could increase its financial risk and make it more vulnerable to economic downturns and volatility. Usually, a low debt-to-equity ratio is seen as a sign of financial stability and tends to boost investor confidence.
- Return On Equity (ROE)
Raising capital is not sufficient; what a company does with that money and how effectively it utilises it to generate more money is also very important. And this is exactly what the ROE helps you gauge as an investor. The ROE is arrived at by dividing the net income of a company by the average shareholders’ equity. A higher ROE is ideal because it tends to signify that the company is optimally utilising shareholders’ money to produce more profits for them.
- Operating margin ratio
The operating margin ratio is a key profitability ratio that helps measure a company’s operational efficiency — how well it manages its operating expenses and what percentage of each rupee of revenue it retains as operating profit. Operating profit is the profit after accounting for costs like wages and raw materials but before paying interest or tax. The higher the operating margin ratio, the better it is, because this indicates that the company is able to manage and run its core business well.
- Quick ratio
The quick ratio is also often referred to as the ‘acid-test ratio’. It’s a measure of a company’s short-term liquidity, and helps assess whether a company can meet its current financial obligations through its liquid assets like cash, account receivables, etc. The formula for this ratio is: current assets minus inventory, the whole divided by current liabilities. A higher quick ratio is considered good as it is a sign that the company can meet its immediate financial obligation, and indicates low liquidity risk.
Significance of financial ratios in evaluating investments
Financial ratios are helpful in giving you a snapshot of a company’s overall financial health and performance. They help you assess how efficiently it is using its resources to generate profits, how much it relies on debt for its operations, what its liquidity risk is, and more. In general, they allow you to make sense of the numbers reported by the company every quarter and financial year.
You can use financial ratios to compare a company’s performance to its own past performance as well as to that of its peers to assess its competitiveness. This can allow you to understand whether it is underperforming or overperforming compared to industry standards. In fact, it’s crucial to keep industry standards in mind when looking at financial ratios, because what may be a low debt-to-equity ratio for a tech company may be a high ratio for a utility company.
Financial ratios that indicate solvency and liquidity also help assess the risk associated with investing in a certain company. For instance, liquidity ratios like the quick ratio offer a glimpse into a company’s ability to meet its short-term obligations. Hence, financial ratios make it possible for you to make informed, data-driven investment decisions.
More tools for informed decision-making
In addition to financial ratios, there are other tools that you can use for making strategic investment decisions. One such tool is Artificial Intelligence (AI), and this requires minimal time, effort, and market knowledge.
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