Meaning of Financial RatiosFinancial ratios are created with the use of numerical which are taken from financial statements to gain meaningful information about a company. It might not be possible for every investor to meet a company’s management or do an in-depth study of their financials. In such situations, financial ratios are key to understanding the health of the company. As it provides beneficial information about the company such as balance sheets, cash flow and income statements etc. Financial ratios are the perfect tool for investors to measure the health of a company.
Importance of Financial RatiosIt is essential for investors to understand key financial ratios, their meaning and impact on the stocks. Financial Ratios help:
- Investors in deciding whether to invest in a company or not.
- Investors track the company’s performance and can help early identification of trends.
- Investors compare the performance of the company against its competitors and industry as a whole.
Types of Financial RatiosFinancial Ratios are divided into various types based on the information that they provide. The key types of financial ratios are: 1. Leverage Ratios: Helps measure company’s debt 2. Efficiency Ratios: Helps measure company’s efficiency in using its resources 3. Profitability Ratios: Helps measure company’s ability to generate profits/income 4. Liquidity Ratios: Helps understand company’s ability to repay short-term and long-term loans. 5. Market Value Ratios: Helps evaluate the share price of a company. While there are several types of financial ratios, today we will understand the meaning and formulas of the 9 most basic financial ratios.
Financial Ratios - Types, Meaning & Formulas
Liquidity RatiosLiquidity ratios such as current ratio, acid-test ratio etc helps investors understand if the company has enough assets to repay its short-term and long-term loans. Let us understand the key types of liquidity ratios, their formulas and what they mean for an investor.
1. Current RatioCurrent ratio measures the company’s ability to repay short term loans with existing assets. Current Ratio Formula = Current Assets / Current Liabilities A high current ratio means that the company has sufficient cash to meet short term liabilities and is financially strong. Whereas, a low current ratio reflects poor financial health and may also indicate default.
2. Quick RatioQuick ratio is also known as Acid-test ratio and evaluates a company's ability to repay its short term liabilities with its quick assets. Quick Ratio/Acid-test Ratio Formula: Current assets - Inventories / Current Liabilities
3. Operating Cash RatioThis financial ratio highlights the number of times a company can pay off its liabilities from generated revenue. Operating cash Ratio Formula: Operating cash flow / Current Liabilities
4. Cash RatioCash ratio evaluates a company’s ability to repay its short term liabilities with cash and cash equivalents. Cash Ratio Formula: Cash & Cash Equivalents / Current Liabilities
Leverage RatiosLeverage ratios show the debt (borrowings) of a company. Debt to Equity ratio is one of the most important ratios to analyse a company.
1. Debt to Equity RatiosDebt to Equity ratio shows the total debt of a company against shareholder’s equity. A high debt to equity ratio is not a favourable sign for equity investors as it signifies high risk. Debt to Equity Ratio Formula: Total Liabilities / Shareholder’s Equity
2. Interest Coverage RatiosThis financial ratio signifies a company's ability to pay its interest obligations. High interest coverage ratio means that the company can make timely interest payments and is a good sign for debt investors. Interest Coverage Ratios Formulas: Operating Income/Interest Expenses
Profitability RatiosProfitability ratios like ‘Return on Equity’ ratio highlights a company’s ability to generate profits (returns) using its equity capital. Return on Equity Ratio Formula: Net Income / Shareholder’s Equity
Market Value RatiosMarket Value ratios help in evaluating whether the stock prices are undervalued or overvalued. Earnings Per Share (EPS) & Price-to-Equity (P/E) ratios are some of the most important financial ratios.
1. Earnings Per Share (EPS) RatioEarnings per share is the net income earned for every outstanding share. Earnings per share formula: Net Income / Total outstanding shares A high EPS ratio means that the investment is worthwhile and the company is capable of generating high dividends for its equity shareholders.
2. Price to Equity (P/E) RatioP/E ratio is one of the most important ratios to analyse a company. P/E ratio helps investors understand the relative value of a company’s share price to its earnings. Price to Equity Ratio Formula: Share Price / Earnings Per Share
Key Financial Ratios of Top Indian Companies
|Top Stocks||P/E Ratio||Return on Capital Employed||Debt to Equity||Return on Equity||PEG Ratio|
|Reliance Industries Limited||32.3||10.70%||0.42||10.30%||2.28|
|Tata Consultancy Services Limited||34.7||47.80%||0.08||37.30%||3.25|
|Hindustan Unilever Limited||77.1||117%||0.00||85.70%||5.80|
|HDFC Bank Limited||26.3||7.31%||7.56||16.50%||1.28|
|Housing Development Finance Corporation Limited||25.3||11.10%||2.97||19.20%||1.28|
|Kotak Mahindra Bank Limited||39.7||7.35%||4.86||13.70%||1.76|
|Bharti Airtel Limited||-||5.45%||2.69||9.83%||-|
|ICICI Bank Limited||22.8||5.90%||8.25||9.46%||-8.15|