Analyzing different aspects of financial statements helps us calculate different financial ratios easily as it provides various metrics that help investors analyze the financial health of a company and whether or not to invest in the company. Let us understand financial ratios in detail and their significance in this article.
What are Financial Ratios?
Financial Ratios are quantitative measures used to assess the performance, health, and efficiency of a company. The numerical values are taken from financial statements, balance sheets, and other indicators that help to calculate financial ratios, which represent the financial status of a company.
Financial ratios are used to offer insights into the financial health of a company. It tells whether a business can manage its revenues, debt, and other financial assets. In this article, we will learn more about financial ratios in detail.
Financial Ratios: Key Takeaways
- Financial ratios are calculated by analyzing financial statements.Â
- It is broadly divided into three major categories i,e profitability ratio, valuation ratio, and leverage ratio.
- Financial ratios help investors compare companies based on their performance, market cap, and competitors.
Significance of Financial Ratios
Financial ratios are important parameters for anyone who is a frequent market investor or interested in financial products and services. They offer valuable insights about a company which become a deciding factor in whether or not to invest in the company. Some of the points taken into account while evaluating the financial ratios of a company are mentioned below.
- Financial ratios help analyze company performance over a specific period of time.Â
- These ratios also help evaluate different companies of different sizes in the same sector based on their industry benchmarks.
- Know whether the stock of a particular company is overvalued or undervalued based on various financial ratios such as the P/E ratio, DE ratio, PEG, PS Ratio, and much more.
- Lenders and creditors use financial ratios to assess whether a company can pay debts back or not. For example, debt to asset, and debt-to-equity ratios are used to determine the financial risks of lending the company.
- Return on Asset and inventory management signifies how well the company is managing its assets.
- Price to Earning Ratio and Price to Book Ratio help analyze market risk by comparing companies based on their valuation and earnings.
Now you must understand whether or not financial ratios are important. Whenever you need insights related to companies financial ratios are the best indicator that provides accurate predictions based on a numerical value. With financial statements, you can compare the exact values not just the approximate calculations.
Types of Financial Ratios: Broad Classification
Financial ratios are bucketed under three broad categories i,e profitability ratio, valuation ratio, and leverage ratio. Investors cannot predict whether a company is the right choice by analyzing only a single parameter of the financial ratio. It is important to analyze combined financial ratios including valuation ratios, operational ratios, profitability ratios, leverage ratios, and more. We will know about them in detail here.Â
1. Profitability Ratios
As the name clearly suggests, a profit ratio is used to measure a company’s ability to make a profit after taking into consideration every factor such as liability, revenue, assets, cashflows, and more. This is one of the most important ratios as it helps to determine whether a company might be able to recover its Return on Investment (ROI).Â
There are many profitability ratios that are used to measure a company Some of the major profitability ratios are given below.Â
- Operation Ratio: Operation Ratio is obtained by dividing the expense of an organization by its operating income. It measures what percentage of a company’s revenue is left after paying for variable costs of production, such as raw materials, products, wages, etc. It is represented by the formula given below.
- Net Profit Margin: This ratio is obtained by dividing net income by net sales in a company. This percentage evaluates the net profit that remains after covering all expenses.Â
- Return on Capital Employed (ROCE): This ratio is used to measure how efficiently a company uses its capital to make a profit. This ratio takes into account both equity and debt to get a comprehensive view of capital utilization. A higher ROCE indicates that a companyÂ
The EBIT signifies operating income or the ability of a company to generate from its operations inside the companies excluding interest and taxes.Â
2. Valuation Ratio
This financial ratio is used to calculate the market value of a company compared to its performance. It helps investors decide whether the current stock of a company is undervalued, overvalued or justified price.Â
To calculate the valuation ratio of a company divide the market capitalization of the organization with the total book value of the company from its financial statement or balance sheet.Â
- Price to Earning Ratio (P/E Ratio): This indicates how much investors are willing to pay related to its per-share earnings. The lower the PE ratio more attractive the investment potential. The formula for the PE ratio is obtained by dividing the market share value by earnings per share.Â
- Price to Sale Ratio (P/S Ratio): The price-to-sale ratio represents the value of a company’s stock to its revenue. It can be obtained by dividing the market capitalization value of a company by its total revenue/sales. A good PS ratio is below one. The lower the value of the PS ratio more better is to invest in that company.
- EBITDA Ratio: EBITDA stands for Enterprise before Interest, Taxes, Depreciation, and Amortization. This ratio represents how efficient a company’s operation model is. It measures the total overall value of a company excluding taxes, depreciation, interest, etc.
         EBITDA = Operation revenue – operations expenses
        EBITDA Ratio = EBITDA/ (Total Revenue – Other income)
3. Leverage Ratio
It is also known as the Solvency Ratio or Gear Ratio. This ratio indicates how much the company is financing its operations using debts. This ratio provides insight into the financial structure and risk level of investing in the company.Â
It represents a company’s ability to sustain its day-to-day operations. Companies also need to pay their bills and different outstandings.Â
- Debt to Equity Ratio (D/E Ratio): This ratio represents the total debt of a company it is using to finance its operations or assets to its total shared equity. It is obtained by dividing the total debt by the total equity.Â
A higher debt-to-equity ratio represents that the company might not be able to generate enough cash to fulfill its debts. For a small or medium-sized company, a debt ratio of 1.5 or less is considered better.Â
- Debt to Assets Ratio (D/A Ratio): This ratio is obtained by dividing a company’s total debt from its various assets. It represents how much debt a company carries as compared to the total assets it owns. For a normal small or mid-sized company DA ratio of 1 or less is considered good.Â
- Equity Ratio: This ratio indicates that a company is using debts to fulfill its requirement for assets. The higher the Equity ratio more is the financial risk for long-term investing in the company.Â
A low equity ratio is a better sign for investors, as the company is getting a higher return to acquire its assets and is not completely dependent on shareholder’s equity.
Some More Major Financial RatiosÂ
Let us look at some more financial ratios considered important for investors below.
1. Return on Equity (RoE Ratio)
This Return on Equity (ROE) is important as it helps investors assess the return shareholders earn for every unit they invest in the company. It measures the enterprise’s ability to generate profits from the investment made by its shareholders. It measures the efficiency of a company in generating profits.Â
-
- The higher the ROE, the better the chance for investors to get higher returns on their investments.
- A higher ROE also represents good cash flow within the company.Â
- ROE = Net Profit/Shareholders Equity*100
- A higher ROE represents a higher level of management performance.Â
- The DuPont identity is used to break down the RoE into three major components. Check the formula below.
Dupont Identity RoE = Profit Margin X Asset Turnover X Equity Multiplier
Here, Profit Margin =Â Net Income/Revenue
Asset Turnover =Â Revenue/ Total Assets
Equity Multiplier = Total Assets/Total Equity
- The formula for DuPont’s identity cancels out each other to return the original formula for RoE but it helps to analyze various aspects of shareholder’s equity. For example, the Net income of a company is Rs 500,000 and the shareholder’s equity is INR 2,000,000. We can calculate the ROE for the company using the metrics above ROE = 500,000/2,000,000 X 100 = 25%
- This ROE represents that for every amount of shareholder’s equity, the company generates 25 percent of profit over the current financial year. This is a strong indicator of the company’s profitability.
2. PAT Margin
It stands for Profit After Tax (PAT) and is used to calculate the profit after Tax margin by using PAT/ total revenue.Â
-
- PAT is used in Annual reports
- It does not consider other expenses such as depreciation, finance costs, and others at an operating level.
- All expenses are deducted from the total revenue of a company to identify the company’s overall profitability.
- PAT Margin = [PAT/Total Revenues]
3. Return on Assets (RoA)
Return on Asset (RoA) evaluates the effectiveness of management inside a company to use available assets to generate profits. The higher the value of RoA, the better the probability of returns.Â
-
- A return on investment is the amount of profit generated over an asset or investment over time. It might be in percentage or price change.
- RoA = Net Income/Average Total Assets where, Net income = Earnings Before Taxes (EBT) – Taxes
Major Breakthrough in Financial Ratios
- Financial ratios are not singular criteria for measuring business health; they are a collective approach to determining the suitability of investing in a business.
- It is one of the best methods to compare a company’s competitors and develop an opinion.
- A higher RoE is better if the debt of the company is not higher.
- The higher the value of RoE the better the chance of higher returns.
- DuPoint helps to analyze RoE after breaking it down into three major categories to analyze the debt factor.
- Financial ratios are more effective when they are compared to different companies in the same sector.
Learn Investment Strategies with PW Skills
Learn the major fundamentals of investments, financial terminologies, basic principles of investing, and more to become an expert financial manager and draw effective financial strategies with our Financial Mastery Analysis and Modeling Course.Â
Get a strategic hold on finances with in-depth learning through interactive classes covered by expert mentors, practice exercises, certification, projects, and much more only at pwskills.com
Financial Ratios FAQs
Q1. What are Financial Ratios?
Ans: A financial ratio is a useful metric of a company that conveys the financial health and well-being of a company based on various factors. Some of the major financial ratios are leverage ratios, profitability ratios, operational ratios, and more.
Q2. What are the three major categories of financial ratios?
Ans: Financial ratios can be categorized into three major categories given below.
Profitability ratio
Valuation Ratio
Leverage Ratio
Q3. What is a Return on Equity Ratio?
Ans: Return on Equity ratio signifies how much return a shareholder can make over their investment in the company. The higher the RoE better the chance of making good returns from the company.
Q4. What is the DuPont method?
Ans: The DuPont method is used to calculate the Return on Equity of an enterprise. It is also known as the DuPont Identity or DuPont Model.
