Just like a magnifying glass zooms in on tiny things, financial ratios zoom in on a company’s financials. They’re like super lenses for investors and smarty-pants. These ratios make the money details crystal clear, painting a vivid picture of how a company is doing financially.
In this blog, we’ll understand the basics of financial ratios so you can zoom in on the nitty-gritty of any company and understand their financials.
Building Blocks for Financial Ratios
When it comes to financial ratios, you start with financial statements. These statements have different parts, such as:
- Assets and Liabilities
- Sales Revenue
- Gross Profits
- Operating Expenses
- Operating Profits and more
The Importance of Financial Ratios
Financial ratios are like detectives for a company’s financial statements. They tell us a lot about how well a company is doing financially. Investors, managers, and shareholders use them to make smart decisions. Let’s look at why these ratios are so important:
- Checking Financial Health:
Financial ratios help us figure out if a company is financially healthy. By looking at their financial statements, investors can decide if it’s a good idea to invest in the company.
- Keeping an Eye on Performance:
Investors can use financial ratios to watch how well a company is doing over time. This helps them see if the company is overperforming or underperforming.
- Spotting Strengths and Weaknesses:
Financial ratios can show investors where the company is doing really well and where they’re not doing so great. This helps them decide if the company is a good buy or not.
Key Foundations for Financial Ratios
With a bunch of financial ratios to look at, the most crucial ones are sorted into these main categories: liquidity, leverage, profitability, efficiency and market value.
This ratio shows if a company is capable of meeting its short-term obligations. Current Ratio and Quick Ratio are used to assess the short-term obligations of the company. The current ratio is a good example of a liquidity ratio. Let’s understand it.
Current Ratio: This ratio measures whether a company can pay off its current liabilities using current assets. Here is the mathematical formula:
Current Ratio = Current Asset/Current Liabilities
Let’s consider an example, XNR company has a current asset of ₹1,000 and current liabilities of ₹700. The current ratio of XNR is 1.4. This indicates that XNR company can clear its current liabilities with its current assets.
Remember, a company with a higher current ratio can quickly pay off its current liabilities with its current assets. A lower current ratio indicates the company can’t pay off its current liabilities quickly.
Investors can use this ratio to evaluate a company’s long-term health and the impact of its capital and finance structure. The debt-to-equity ratio measures the long-term health of a company. Let’s understand this ratio.
Debt-to-Equity: The debt-to-equity ratio compares total debt to total equity to measure the riskiness of the company’s financial structure. Investors should monitor this metric, as it provides an early warning sign when companies are knee-deep in debt and may have trouble meeting payment obligations.
Debt to Equity Ratio = (Long-Term Debt + Short Term Debt + Leases) / Shareholders’ Equity
Suppose BTB Company has a total debt of ₹1,00,000 and a total equity of ₹2,00,000. Thus, BTB company maintains a Debt-to-Equity Ratio of 0.5, signifying that for every ₹1 of equity, there is ₹0.5 of debt.
A good indicator for the debt-to-equity ratio varies by industry and company. However, in general, a ratio below 1 indicates that a company has more equity than debt, which is often considered healthier and less risky.
As the name suggests this ratio indicates how efficiently a company generates profits. Return on equity is a metric used to measure how the company generates profits. Let’s take a closer look at it.
Return on Equity:
Return on Equity (ROE) gauges how well a company can make profits from the money shareholders have invested in it.
Return on Equity = Net Income / Shareholders’ Equity
AEW Company has a net income of ₹500,000 and shareholders’ equity of ₹2,000,000. Therefore, the Return on Equity for this company is 0.25 or 25%. This means for every rupee of shareholders’ equity, the company generates 25 paise in net income.
A strong indicator of Return on Equity (ROE) often reflects a company’s efficiency in utilizing shareholder investments to generate profits. Higher ROE values, relative to industry averages or competitors, are generally considered positive signs of performance and efficiency.
Efficiency ratios reveal how a company manages its investments in fixed assets such as machinery and buildings, indicating resource utilisation. The inventory turnover ratio is a good measure to assess the efficiency of a company.
Inventory Turnover Ratio: The inventory turnover ratio measures how efficiently a company manages its inventory.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Take a look at this example to understand this ratio ABE company has an average inventory value of ₹500,000 and its cost of goods sold (COGS) during a specific period is ₹2,000,000. This means the company turns over its inventory 4 times in the given period.
A higher inventory turnover ratio indicates that the company’s sales are higher and the demand for the inventory is higher. While a lower inventory turnover ratio shows the company has poor sales and carries too much inventory.
Financial ratios serve as essential tools, offering insights into a company’s financial health and performance. They aid investors in gauging potential risks, understanding profitability, and making informed decisions. Careful analysis and interpretation of these ratios are crucial for prudent investment choices.
Financial ratios analysis often simplifies complex historical financial data, providing benchmarks for performance, highlighting the strengths and weaknesses of a company, aiding in comparisons with its peers, and helping investors make informed decision-making in financial analysis.
Financial ratios greatly influence stock prices by assessing a company’s performance and financial health. This evaluation impacts investor decisions, potentially affecting the stock’s price.
Investors must consider various aspects while investing in a company, some of the important ones being its financial health, strength of management, competitive advantage, stock valuation, historical performance, etc.
The liquidity ratio measures how quickly a company can pay off its short-term obligations. Ideally, a higher liquidity ratio, the more solvent the company.
Financial ratios come with a few limitations. It is mainly dependent on historical financial data and doesn’t fully capture future trends or market changes. Ratios are derived from accounting principles and may not capture the company’s true economic value or performance.