Key financial ratios you should check before picking a stock

5 August 2022
6 mins read
Key financial ratios you should check before picking a stock

It is crucial to understand the financial or fundamental strength of a company while investing in the equity market. This can be done by analysing balance sheets, profit and loss accounts, cash flow statements and annual reports. However, going through each and every data point can be a tedious job for any novice investor. Another way is to zero in on financial ratios which can help you to understand the company’s health in no time.

In general, ratio analysis is crucial for making investment decisions. It not only helps in knowing how the company has been performing over the past years but also helps in doing comparative analysis between the companies of the same industries and identifying the best firm within the industry for making investment decisions.

Below are major financial ratios which can help investors in simplifying their investment decision.

Debt-to-Equity Ratio

This ratio helps to understand how much external funding is involved in running the business in proportion to own capital. It is considered that lower the debt-to-equity (D/E) ratio the better it is and higher the ratio riskier it is. However, an investor should not do this in isolation. As long as the company with high debt is contributing a return higher than the interest charges on the external loan it will contribute in enhancing the shareholders value. However, if the interest cost is more than the return generated from the borrowed amount it may eventually affect the business as well as shareholders value.

On the other hand, a company with low or zero or low debt-to-equity ratio can be assumed to have more scope for future expansion as the fund raising would be easy for the company.

For example: you want to start a business and you need a capital of Rs 2 lakh. You have Rs 1 lakh and you borrowed the rest of it from your relative or bank. In this case, the debt-to-equity ratio is 1:1. That means that for every Rs 1 of equity you have the same amount of debt. In general, debt-to-equity of less than 1 is considered safer.

Current Ratio

This ratio helps in understanding the liquidity status of the company. It tells an investor about how equipped the company is in meeting its short term obligation with its short term assets. Higher current ratio indicates that the company is more capable of meeting its short term liabilities. Investors can thus assume that the day to day activities of the company will not get affected due to working capital pressure.

Current ratio of less than one is a matter of concern and one should be cautious while investing in such companies. While calculating the ratio the current asset also includes inventories and receivables of the company. Sometimes companies find it difficult in converting the inventory into sales or trouble in turning receivables into cash. This may pose a threat in meeting the obligation arising at the point and therefore investors may also calculate acid-test ratio, similar to current ratio with exception that it does not include inventory and receivables.

The ratio is calculated by dividing current assets by current liabilities.

Current Ratio =  Current Assets  /   Current Liabilities

The ratio usually compares current assets with current liabilities and shows whether the current assets are enough to settle current liabilities.

Assets Turnover Ratio

This ratio measures how efficiently the company is using its assets to generate topline or revenue. A higher ratio indicates that a company is earning more revenue as compared to the amount spent on a particular asset. As a result, this shows how optimally the management is using the particular asset. Before going ahead, one should note that here the comparison should be made between the companies of the same industry. In any asset heavy industry, this ratio usually stays on the lower end, while the asset turnover ratio stays on the higher-end where the asset base is small. Asset turnover ratio can be calculated by dividing net sales by average total assets. Suppose there are two companies ABC and XYZ from the same sector having asset turnover ratios of 165 and 150, respectively. This shows that the company ABC is operating its business more efficiently as compared to competitors with a lower ratio.

Operating Profit Margin

The ratio helps in understanding the operational efficiency and pricing strategy of the company. A higher operating profit margin, or OPM, shows the efficiency of the management in procuring the raw materials and converting them into finished products. It measures how much profit a company makes on sales after paying for variable costs of production such as wages and raw material. One should always look for companies with rising operating profit margin.

Operating profit margin is crucial for both investors as well as creditors as it shows how robust and profitable the company is. In simple words, it is calculated by dividing operating profit by total revenue.

Let’s take an example:

Operating Profit: Rs 2,00,000

Total Revenue: Rs 10,00,000

By dividing operating profit by total revenue, we will get operating profit margin  as 0.20, which shows that 0.80 paise of each rupee of revenue is used to cover variable cost. While comparing the ratio, it is advisable that one should use it with companies available in the same sector.

Return on Equity

Return on equity, or ROE, helps in measuring the company’s ability to generate profits from its shareholders’ investments. In other words, it is calculated by dividing net income by shareholder equity. Here again, the higher the ratio the better it is. The ratio also helps in comparing the profitability of the companies in the same industry. Rising ROE indicates that the management is doing well in growing the business of the company and at the same time adding value to the shareholders wealth. Analysts believe that return on equity in the range of 15 per cent to 20 per cent is generally considered to be quality investment.

Price-to-earnings (P/E) ratio and PEG ratio

The ratio is calculated by dividing the stock price by earnings per share (EPS) of the company. This is a valuation ratio which tells how much the market is willing to pay for a stock based on its past or future earnings. Lower the ratio cheaper is the valuation and vice versa. However, the ratio is not the sole criteria for investment decisions. One should always compare the P/E ratio with other valuation parameters. Analysts believe that forward P/E ratio is more important than historical.

Usually, companies which grow faster than average typically have higher price-to-earnings. A higher P/E ratio shows that investors are willing to pay a higher share price today because of growth expectations in the future. For example, if a company trades at a P/E of 50 times earnings against the benchmark P/E of 30 times shows that investors expect higher growth in the company as compared with the market.

Another important ratio is PEG ratio which is calculated by dividing PE ratio by EPS growth rate. It also tells an investor whether the stock is undervalued or overvalued. A PEG ratio less than 1 indicates that stock is undervalued and its growth rate would outpace the PE ratio and thus would make stock more attractive. For example, PE ratio is 20x (say Rs 400 stock price and EPS is Rs 20) and growth rate of 25% means PEG ratio is 0.8 suggesting that the following year, the PE ratio will become 16x (stock price of Rs 400 and EPS Rs 25). The stock therefore becomes more attractive for buying.