Types of Must-Know Financial Ratios To Analyze Any Company Before Investing

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Every company that is worth investing in must have achieved some financial stability and produced consistent proof of performance. Therefore, for both institutional and retail investors, it becomes of paramount importance to analyze a company on key financial parameters before investing in it. The analysis needs to be both quantitative and qualitative in nature, measuring the past performance and future potential of the company.

Such analysis is called Fundamental analysis and is performed by a thorough study of the financial statements of the company. There is a goldmine of information in the Balance Sheet, Profit and Loss Statement, and Cash-flow statement for an average investor to determine how a company is faring. But instead of spending hours to find the meaningful data in a lengthy annual report, this analysis can be performed efficiently with the help of financial ratios.

Financial Ratios and Their Types

Financial ratios are developed by using two specific numerical values, taken from the financial statements of a company, to derive a relative magnitude. Financial ratios are designed to assess the overall financial condition of a company and help the investors make informed investment decisions. They can be broadly categorized into five groups based on the information being analyzed:

1. Liquidity Ratios: These measure the availability of cash with a company to manage short-term and long-term liabilities. Liquidity ratios include Current Ratio (also known as Working Capital Ratio), Quick Ratio (also known as Acid Test Ratio), Cash Ratio, and Operating Cash-flow.

2. Efficiency or Activity Ratios: These are used to evaluate how well a company uses its non-cash assets and resources to generate cash assets. Efficiency ratios include Asset Turnover, Inventory Turnover, Receivables Turnover, and Cash Conversion Cycle.

3. Profitability Ratios: These measure a company’s ability to generate income and returns on equity employed. Profitability ratios include Gross Margin, Operating Margin, Return On Assets (ROA), Return on Equity (ROE), and Return On Capital Employed (ROCE).

4. Leverage or Debt Ratios: These are used to analyze the debt level of a company and its ability to repay debt. Leverage Ratios include Debt Ratio, Debt to Equity Ratio, Interest Coverage Ratio (also known as the Times Interest Earned Ratio), and Debt Service Coverage Ratio.

5. Market Value Ratios: These evaluate the share price, dividends, and net returns of a company’s stock. Market value ratios include Earnings Per Share (EPS), Price to Earnings (P/E), Dividend Yield, Price to Book Value, EV/EBITDA, and EV/Sales.

Types of Financial Ratios

Calculating Key Financial Ratios

Each financial ratio can be calculated using a defined formula and offer a standardized assessment of a company’s financial health. Let’s look at each ratio and its formula to understand how they help in analyzing a company.

Current Ratio

Current Ratio = Current Assets/Current Liabilities

This ratio compares the assets and liabilities of a company at any given time, determining its ability to manage short-term liabilities, especially its working capital. A current ratio value between 1.5 to 3 is considered good, while a value less than 1 may indicate liquidity problems and financial instability.

Quick Ratio

Quick Ratio = (Current Assets — Inventories) /Current Liabilities

This ratio measures whether a company’s current assets, excluding its inventory, can cover its short-term liabilities or not. Only the most liquid assets that can be quickly converted into cash are considered. Any value greater than 1 is considered a good quick ratio.

Cash Ratio

Cash Ratio = Cash and Cash Equivalents/ Current Liabilities

This ratio is more conservative and measures only the absolute liquidity available to a company to cover its short-term liabilities. A value between 0.5–1 is considered a good cash ratio for a company.

Operating Cash-flow Ratio

Operating Cash-flow = Operating Cash-flow/Total Debts

This ratio measures how well a company can cover its current liabilities with the cash flow generated in a given period through its core operations. A value of 1:1 is considered good for this ratio; anything lower may mean that the business is paying off its obligations through cash generated from sources other than its core operations.

Asset Turnover Ratio

Asset Turnover = Net Sales/ Average Total Assets

This ratio measures how well a company uses its assets to generate income for a given fiscal year. The higher this ratio, the more efficient the company. However, the ideal value for this ratio can vary from sector to sector and the nature of the business.

Inventory Turnover Ratio

Inventory Turnover = Cost of Goods Sold (COGS)/ Average Inventory

This efficiency ratio measures how many times in a given period a company sells off its stock inventory and replaces it. Any value between 5–10 is considered generally good. A higher value also means a company has a good balance between inventory sufficiency and order frequency.

Receivables Turnover Ratio

Receivables Turnover = Net Credit Sales/ Average Accounts Receivable

This ratio measures how many times a company can convert its receivables into cash, in a given time period. It's best to compare this ratio for a company with the industry average to effectively measure how well the company is managing its receivables.

Cash Conversion Cycle

Cash Conversion Cycle = Inventory Conversion Period + Receivables Conversion Period — Payables Conversion Period

This ratio measures how quickly a company can generate income through inventory sales and receivables collection to pay off its payables. A shorter cash conversion cycle is considered a good indicator of a company’s management.

Gross Margin Ratio

Gross Margin = Gross Profit/ Net Sales

This profitability ratio compares the gross profit of a company to its net sales, measuring how much profit is generated after paying off COGS. The ideal value for this ratio varies with industry, however, as a thumb rule, anything between 10–20% is considered good.

Operating Margin Ratio

Operating Margin = Operating Income/ Net Sales

*Operating income = Earnings Before Interest and Tax = Operating Revenue — Operating Expenses

This ratio measures the operating efficiency of a company by comparing its operating income with net sales and indicating the percentage of profit that a company can produce from its core operations.

Return on Assets (ROA)

Return on Assets = Net Income/ Total Assets

This ratio measures the total profitability of a business in relation to its total assets. A higher ROA indicates efficient utilization of a company’s assets to generate positive returns.

Return on Equity (ROE)

Return on Equity = Net Income/ Average Shareholder’s Equity

This ratio measures a company’s profitability against the equity invested by its shareholders. ROE value upward of 15% is considered a positive indicator and contributes towards higher stock valuation.

Return on Capital Employed (ROCE)

Return on Capital Employed = Earnings Before Interest and Tax (EBIT)/ Capital Employed

This ratio measures a company’s profitability against all the available capital. A higher ROCE is considered a good indication of the financial performance of a company and its capital efficiency.

Debt Ratio

Debt Ratio = Total Liabilities/ Total Assets

This ratio measures the number of assets that a company is financing through debt. A debt ratio lower than 0.4 is considered good for considering a company for potential investment. A debt ratio above 0.6 can make a company an undesirable candidate for further lending or investment.

Debt to Equity Ratio

Debt to Equity (D/E) = Total liabilities (Long-term Debt + Leases)/ Shareholders’ Equity

This ratio evaluates a company’s total liabilities against its shareholders’ equity. A D/E ratio below 1.0 is considered good, whereas a value above 2.0 is considered a red flag.

Interest Coverage Ratio

Interest Coverage = Operating Income/ Interest Expenses

This ratio analyzes whether a company is capable of paying interest on its outstanding debt. A value of 3 or more is considered good for the interest coverage ratio.

Debt Service Coverage Ratio

Debt Service Coverage = Operating Income/ Total Debt Service

This ratio measures whether a company is capable of paying not just interest but the entire debt service (principal as well as lease payments).

Earnings Per Share (EPS) Ratio

EPS = Net Earnings/ Total Outstanding Shares

This ratio measures the net income earned against each outstanding share. Higher EPS indicates better profitability and is considered good by investors.

Price To Earnings (P/E) Ratio

P/E = Share Price/ Earnings per share

This ratio compares the price of a company’s stock with the earnings generated per share. It helps in analyzing the company’s valuation and investment potential relative to the industry average.

Dividend Yield

Dividend Yield = Dividend Per Share/ Share Price

This ratio measures the amount of dividend allocated to shareholders against the share price paid. A dividend yield between 2%- 4% is considered good for a company.

Price to Book Value Ratio

Price to Book Value = Market Price per share/ Balance sheet price per share

This ratio measures whether a company’s stock price is fairly valued, undervalued, or overvalued. A higher value means the market is willing to pay a premium to buy the company’s share. A value below 1 means the company’s shares are undervalued.

EV/EBITDA Ratio

EV/ EBITDA = Enterprise Value/ EBITDA

This valuation ratio is used to determine the fair market value of the company by also factoring in the debt. A high value of this ratio means the company is overvalued. Therefore, a lower value may be considered good for potential investments.

EV/Sales Ratio

EV/Sales = Enterprise Value/ Net Sales

This ratio compares a company’s value to its net sales. A lower value of this ratio can mean the company stock is affordable, whereas a higher value may make it expensive.

Conclusion

In addition to these key ratios, there are other metrics that are used to analyze a company to determine its financial health and investment potential. However, with these key ratios, both internal and external evaluations can be done comprehensively to make informed decisions.

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