Financial ratio analysis and how to use them

Investment in Stock requires financial ratio analysis to check the company’s true condition. Let’s discuss the financial ratios that one should look at before investing in a stock for analysis.

Financial ratio analysis helps in fundamental analysis because they allow you to:

✓ Compare several companies financials against each other. Financial ratios give you a relatively common basis in which to rank companies, usually in the same industry, against each other.

✓ Draw conclusions from all the financial statements. By pulling numbers from the income statement and balance sheet, you can glean insights
you’d never get by reading just one of the statements.

✓ Get quick insights. With just a few division problems, you can get a pretty good idea at how skilled a management team is and how well the business is operated.

Generally, Financial ratio analysis  fall into one of five categories, including:

✓ Profitability: These ratios allow you to put the profit, or loss, generated by a company into perspective. These ratios are typically called profit margins. But there are several kinds of profit margins, including gross, operating and net.

✓ Management effectiveness: Ever wonder if a CEO is doing a good or
bad job? Many investors just look at the stock price to make that judgment. But that’s somewhat unfair since the CEO can’t control the minds of investors. However, ratios like return on assets, return on equity and return on invested capital are affected by CEOs’ decisions.

✓ Efficiency: When you invest or lend money to a company, you want to know your cash is being put to good use. And that’s the goal of the efficiency ratios, to indicate how wisely the company is managing its resources.

✓ Financial condition: When you invest in a company, you want to know it has the resources it needs to endure.

✓ Valuation: A stock’s per-share price, while the fixation of most investors, doesn’t tell you much about how expensive the stock is. It’s the stock’s valuation, or how much you’re paying for a company’s earnings, that
matters.

The fundamental analysis brings that same rigor to measuring companies’ leaders, including the CEOs. CEOs, hoping to hang onto their jobs, are infamous for putting the best face possible on their companies’ results. But fundamental analysis lets you, the investor, look past the promises and spin to see how management actually did.

Return on equity

For many investors, the key ratio to pay attention to is a return on equity or ROE. This measure tells you how much profit the company is generating from money entrusted to it from investors. The formula is:

Return on equity = Net income / average shareholders’ equity

Don’t assume that just because a company has a higher ROE than another, it’s a better company. A company’s ROE may be depressed because it has a large investment in assets. These assets might give the company an edge over rivals in the long run. That’s why it’ best to compare one company’s ROE to another’s, in the same industry.

Debt to equity

The debt-to-equity ratio is one of the most basic measures of a company’s debt load. It tells you, at a glance, how a company’s pile of debt compares with the amount of money it has raised from stock investors. The higher the number, the more loaded it is with debt relative to stock. The formula is:
Current portion of long-term debt + long-term debt / total equity × 100

Price-to-book ratio

Many serious fundamental analysts pay the closest attention to the price-to-book ratio. This ratio compares a company’s stock price to its book value, or value of everything the company owes, free and clear of debt. The formula for price-to-book is:
Price-to-book = Company’s stock price / (shareholders’ equity / number of shares outstanding)

The higher the price-to-book ratio, the more investors are paying up for the companies’ assets. The ratio will rise and fall as investors get more confident or less confident about the company and the stock market.

P-E ratio

A stock’s P-E changes every day along with a stock’s price. The formula is deceptively simple:

P–E = Stock price / earnings per share

The higher the P-E, the loftier the company’s valuation is. When you see a P-E get high relative to peers in the same industry, you might begin to wonder if investors are overvaluing the stock. Similarly, if you see a stock’s P-E fall below that of its peers, you might wonder if the company can make changes to its operations to win a higher multiple.

Earnings Per Share (EPS)

Earnings per share or EPS is an important financial measure, which indicates the profitability of a company. EPS is the portion of a company’s profit that is allocated to every individual share of the stock.

EPS = Company’s net income / total number of outstanding shares

For good stock EPS should be increasing for last 5 years

Return on Equity (ROE)

Return on equity signifies how good the company is in generating returns on the investment it received from its shareholders.
Return on Equity = Net Income or Profits/Shareholder’s Equity

It should be greater than 20%.

Price to Sales Ratio (P/S)

The stock’s price/sales ratio (P/S) ratio measures the price of a company’s stock against its annual sales. It can be calculated using the formula:
P/S ratio = (Price per share/ Annual sales per share)

The smaller value is preferred.

Current Ratio

This shows the liquidity position, that is, how equipped is the company in meeting its short-term obligations with short-term assets. A higher figure signals that the company’s day-to-day operations will not get affected by working capital issues. A current ratio of less than one is a matter of concern.
Current Ratio = Current Assets / Current liabilities

Should be greater than 1

Dividend

The dividend is usually a part of the profit that the company shares with its shareholders.
After paying its creditors, a company can use part or whole of the residual profits to reward its shareholders as dividends. However, when firms face a cash shortage or when it needs cash for reinvestments, it can also skip paying dividends.

Increasing for the last 5 years

If you are not aware of stock market terms then you must check our guide on stock market terminologies.