• Stock Market
• Sept 25, 2024
• 5 Mins Read

Key Financial Ratios Every Investor Should Know

While investing in a company in the share market, it is important to assess its financial status, health, and position. It helps you make an informed decision whether to invest in the company. However, how do you calculate it? You cannot or shouldn’t decide to invest only by looking at the company’s share price trends. One of the effective ways of doing this is by calculating key financial ratios. Let’s overview them in this blog.

What is a Financial Ratio?

A financial ratio helps calculate a company’s financial status. It uses data from a company’s financial statements to determine its performance, financial health, and profitability. Investors can do it in various ways. Hence, if you plan to invest in the share market, you should know the different types of financial ratios and use them in your investment analysis. While our share market classes help you understand how to use them, here’s an overview of the different types of financial ratios.

Benefits of Calculating Financial Ratios – Why Should Investors Use Financial Ratios?

Before looking at the different types of financial ratios, here’s how using them benefits you as an investor. In other words, here’s why you should learn financial ratios.

• Assess a company’s profitability
• Understanding its debt levels
• Measure an organization’s ability to meet short-term obligations
• Valuing the company
• Calculate how efficiently a company uses its assets to produce revenue
• Analyze performance trends like profit improvements or rising debt levels
• Evaluate a company’s risk profile

Let’s now see how you can calculate financial ratios in different ways.

Types of Financial Ratios Every Investor Should Know

Here are some types of financial ratios you should know.

• Liquidity Ratios - Current Ratio, and Quick Ratio

  Liquidity ratios measure a company’s capacity to meet its short-term obligations and indicate its financial health. This ratio is measured in different forms, including;

  • Current Ratio: Current Assets / Current Liabilities – This ratio calculates how a company uses its current assets like cash, accounts receivables and inventories to settle liabilities like accounts payable.
  • Quick ratio (Acid-test ratio): (Current Assets – Inventories – Prepaid Expenses) / Current Liabilities – This helps measure how a business’s more liquid assets, like cash, accounts receivable and cash equivalents can cover its current liabilities.

• Profitability Ratios: Gross Profit Margin, Net Profit Margin, ROA (Return on assets), ROE (Return on Equity)

  This ratio helps measure how a company generates profits with available resources over a period. The most common profitability ratios include the following.

  • Gross Margin: Gross profit / Net sales- - It calculates how much profit a business generates after the goods and services cost compared to its net sales.
  • Operating Margin: Operating income / Net sales – This one measures how much profit a company produces from net sales after considering the cost of goods sold and its operating costs.
  • Return on assets (ROA): Net income / Total assets –It helps calculate the profits a company generates from total assets or resources, including current and noncurrent assets.
  • Return on equity (ROE): Net income / Total equity –This helps measure the profit a business generates from shareholders’ equity.

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• Leverage Ratios – Debt-to-Equity Ratio, Interest Coverage Ratio

  These ratios help calculate the amount of a debt of a company.

  • Debt Ratio: Total Debt / Total Assets – It measures a company’s amount of debt to its total assets.
  • Debt to Equity Ratio: Total Debt / Total Equity –– This ratio measures a company’s debt liability compared to the shareholder equity. It is important for an investor to calculate this ratio as when a company goes bankrupt, fulfilling debt obligations is the priority.
  • Interest Coverage Ratio: EBIT / Interest expenses –This ratio shows if a company’s revenue after considering its operating expenses covers interest liabilities or not.

• Efficiency Ratios - Asset Turnover Ratio, Inventory Turnover Ratio

  Efficiency ratios help measure how a company effectively uses its working capital to generate sales. Some ways of analyzing efficiency ratios include the following.

  • Asset Turnover Ratio: Net sales / Average total assets –This ratio calculates how much net sales are generated from a company’s average assets.
  • Inventory Turnover: Cost of goods sold / Average value of inventory –For manufacturing companies with high inventory levels, this ratio helps measure the frequency of inventory use and replacement for operations.

• Valuation Ratios - Price-to-Earnings (P/E) Ratio, Price-to-Book (P/B) Ratio, Dividend Yield

  Valuation ratios help determine a company’s worth. These ratios are calculated in various ways, some of which include the following.

  • Price-to-Earnings (P/E) Ratio:This is calculated price per share / earnings per share. It calculates how much investors are willing to pay for every rupee they earn.
  • Price-to-Book (P/B) Ratio:This is measured as price per share / revenue per share. It compares a company’s stock price to its sales.
  • Dividend Yield:This is calculated using annual dividends per share / price per share. It shows the returns an investor can expect from dividends relative to the company’s stock price.

• Cash Flow Ratios - Operating Cash Flow Ratio, Free Cash Flow

  These ratios help calculate a company’s ability to produce cash relative to its financial obligations, overall operations and expenses. Some types of cash flow ratios include the following.

  • Operating Cash Flow Ratio:It is calculated by cash flow from operations / current liabilities. The ratio helps measure a company’s ability to cover its current liabilities with cash generated from its operations.
  • Free Cash Flow:This ratio is calculated by free cash flow (operating cash flow – capital expenditure) / net sales. The purpose of this ratio is to calculate the cash available after considering capital expenses.

So, that was about some of the key financial ratios every investor should know. Now, you must be wondering how to use these financial ratios while performing investment analysis. The answer, as mentioned earlier, is enrolling in our stock market classes in Pune, where you learn how to use financial ratios and make informed investment decisions. Additionally, our services cover investment options like mutual funds, bonds, debentures, insurance, etc., help you manage your portfolio and increase profitability. Call us at +91 9226903617 to learn more.