Analyzing financial ratios is an important part of fundamental analysis. Fundamental analysis gives us the intrinsic value of any security, which means the true value. For example, if someone sells you a banana worth 5 Rs for 100 Rs, would you prefer to buy it? Maybe not, because you know it’s not worth 100 Rs. Of course, you will prefer to buy it when you can get it for around 5-10 Rs. The same happens with stocks. Investors tend to invest at the fair value so that they get optimum returns on their investment. But how do they do it? There are many aspects of fundamental analysis, and one of the aspects includes analyzing financial ratios.
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What is meant by financial ratios?
Financial ratios are mathematical calculations used to evaluate various aspects of a company’s financial performance and position. These numbers are derived from documents like the income statement, balance sheet, and cash flow statement. These ratios tell us different things about a company, like how profitable it is, how much money it has on hand, how much debt it has, and how efficiently it’s using its resources. They give us a clearer picture of a company’s overall financial health and help investors decide if it’s a good idea to invest in the company. Investors can make a more informed decision with the help of these ratios.
There are many types of financial ratios such as profitability ratios, liquidity ratios, solvency ratios, efficiency ratios. But we will just go through the important and common ratios rather than going deep into this subject.
All the important financial ratios
1) Quick Ratio
The Quick Ratio is also known as the Acid-Test Ratio. It is a simple measure that helps us understand if a company has enough cash to pay its bills right away. It’s like looking at your wallet to see if you have enough money to buy something without needing to sell anything first. The Quick Ratio focuses on the company’s most liquid assets, like cash, short-term investments, and accounts receivable, but it doesn’t include inventory. We calculate it by dividing these liquid assets by the company’s immediate bills.
- If the Quick Ratio is 1 or higher, it means the company can cover its bills easily.
- If it’s less than 1, it might struggle to pay its bills without finding extra money.
Investors and creditors use this ratio to check how financially healthy a company is in the short term.
2) Working Capital Ratio (WCR)
Liquidity plays an important role in any business. Liquidity basically means how easily a company can convert its assets into cash. The Working Capital Ratio gives us an idea of the short-term liquidity of the company, depicting its ability to pay its short-term liabilities. It is calculated by dividing current assets by current liabilities.
- A WCR of 2 or more than 2 shows the good liquidity of a company, indicating that it has twice or more than twice the assets than its liabilities. This can be reassuring for creditors and investors, as it implies that the company is well-equipped to meet its financial obligations in the short term. However, an excessively high working capital ratio may also signal that a company is not efficiently utilizing its assets.
- A working capital ratio of 1 or less indicates that the company might face liquidity issues while paying its short-term liabilities. However, with time, the situation may improve.
3) Earnings Per Share (EPS)
EPS measures the profitability of a company. It is derived by dividing the company’s profit (PAT) by the total number of outstanding shares.
- A higher EPS indicates good profitability for a company.
- EPS can be zero or negative depending on the company’s earnings. If a company is in loss, then EPS will be negative.
4) Price to Earnings Ratio (P/E Ratio)
The P/E ratio, or Price-to-Earnings ratio, is a simple way to figure out if a stock is a good deal or not. Here’s how it works: you take the price of one share of the stock and divide it by how much the company earns per share. The mathematical formula is – Current Share Price/EPS. It basically tells us that how much an investor is paying to get 1 Rs earning from each share.
- A lower P/E ratio might mean that a stock is undervalued and you should consider buying it. But, be careful because it could also mean that the company isn’t doing so well financially.
- On the other side, a higher P/E could mean that a stock is overvalued. However, it might also mean that the company is doing great and could keep doing well in the future.
P/E ratio is compared with the other stocks of the same sector but it’s important to consider other factors such as growth prospects, industry trends, and market conditions alongside the P/E ratio to make informed investment decisions.
5) Debt to Equity Ratio (D/E Ratio)
The debt-to-equity ratio shows how much debt a company has compared to its own money. It is calculated by dividing the company’s debt by its shareholder’s equity, where Shareholder’s Equity basically means total money a company has after excluding debt and liabilities.
- If D/E ratio is high, the company relies more on borrowing, which can be risky. Company will have difficult time to repay it’s borrowings.
- A low ratio means the company relies more on its own funds, which is safer. Investors use this ratio to see if a company can handle its debts. It helps them decide if it’s smart to invest. By looking at this ratio, investors can understand if a company is financially stable and safe to invest in.
6) Return on Equity (ROE)
Return on equity (ROE) is a measure used to see how well a company is using its shareholders’ money to make profits. In simple words, it measures profitability. It’s like looking at how much money you make compared to the money you invest in a business. ROE is calculated by dividing the net income of a company by its shareholders’ equity.
- A higher ROE means the company is generating more profits with the money invested by shareholders. This is good because it shows that the company is using its resources effectively to generate profits. Investors look at ROE to see if a company is a good investment. It helps them understand how efficiently a company is operating and if it’s worth putting their money into.
Conclusion
Financial ratios play an important role while analyzing a stock. These numbers basically tell us how a company is performing. They help us in making smart choices and managing risks in the stock market. Understanding these ratios gives investors confidence and helps them build successful investment strategies. So, next time you’re thinking about buying or selling stocks, take a look at the financial ratios to make informed decisions.