Meaning of Financial Ratios
Financial 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 Ratios
It 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 Ratios
Financial 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 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.
Watch this video to understand liquidity ratio
1. Current Ratio
Current 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 Ratio
Quick 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 Ratio
This 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 Ratio
Cash 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 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 Ratios
Debt 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
Watch this video to understand debt to equity ratio
2. Interest Coverage Ratios
This 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 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 Ratios
Market 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) Ratio
Earnings 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) Ratio
P/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|
P/E ratio, Earnings per share, return on capital, debt to equity ratio are some of the most important ratios to analyse a company. But merely calculating financial ratios will not help you discover the best stocks to buy.
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