Financial Ratios

These ratios measure a company’s ability to meet short-term financial obligations.

1. Current Ratio:

• Formula: Current Assets / Current Liabilities
• Indicates whether the company has enough assets to cover its liabilities in the short term.
• Ideal Range: Greater than 1.
• Example: If the current ratio is 2, the company has ₹2 in assets for every ₹1 of liabilities.

These ratios show a company’s ability to generate profit relative to sales, assets, or equity.

1. Operating Profit Margin:

• Formula: Operating Profit/Net Revenue × 100
• Operating Profit = Revenue - (Cost of Goods Sold + Operating Expenses)
• Net Revenue = Total revenue earned after discounts, returns, or allowances.
• This ratio helps assess a company’s ability to generate profit from its core business operations.

1. Net Profit Margin:

• Formula: Net Profit / Revenue × 100
• Indicates the percentage of profit a company earns on its sales.
• Example: A net profit margin of 20% means the company earns ₹20 for every ₹100 in sales.

1. Return on Equity (ROE):

• Formula: Net Income / Shareholders’ Equity × 100
• Measures how efficiently a company generates returns on shareholder investments.
• High ROE: Indicates effective utilization of equity to generate profit.

1. Earnings Per Share (EPS):

• Formula: (Net Income - Preferred Dividends) / Number of Outstanding Shares
• EPS represents the profit allocated to each share.

Key Insight: Higher EPS often indicates better profitability.

These ratios help investors assess whether a stock is undervalued, overvalued, or fairly priced.

1. Price-to-Earnings Ratio (P/E Ratio):

• Formula: Market Price per Share / Earnings Per Share (EPS)
• Indicates how much investors are willing to pay for ₹1 of earnings.
• Example: A P/E of 20 means investors are paying ₹20 for ₹1 of the company’s earnings.
• Key Insight:
  • High P/E: May indicate overvaluation.
  • Low P/E: Could signal undervaluation.

1. Price-to-Book Ratio (P/B Ratio):

• Formula: Market Price per Share / Book Value per Share
• Compares the market value of a stock to its book value (net assets).
• P/B < 1: Indicates undervaluation.

3. Price to Sales

1. Dividend Yield:

• Formula: Annual Dividends per Share / Market Price per Share × 100
• Shows the return on investment for dividend-paying stocks.
• Example: A dividend yield of 4% means ₹4 in dividends for every ₹100 invested.

These ratios assess a company’s reliance on debt and its ability to manage it.

1. Debt-to-Equity Ratio:

• Formula: Total Debt / Shareholders’ Equity
• Indicates the proportion of debt used to finance the company’s operations relative to equity.
• Ideal Range: Less than 1 for most industries.

1. Interest Coverage Ratio:

• Formula: EBIT (Earnings Before Interest and Taxes) / Interest Expense
• Measures the company’s ability to cover interest payments with its operating income.
• Higher Ratio: Indicates strong financial health.

These ratios measure how effectively a company utilizes its resources.

1. Inventory Turnover Ratio:

• Formula: Cost of Goods Sold (COGS) / Average Inventory
• Shows how efficiently inventory is managed.
• High Ratio: Indicates effective inventory management.

1. Asset Turnover Ratio:

• Formula: Net Sales / Average Total Assets
• Measures how efficiently a company uses its assets to generate revenue.

Financial ratios help compare companies within an industry, aiding investors, analysts, and management in evaluating financial health, efficiency, and profitability.

Key Uses:

• Industry Benchmarking: Compares performance with industry averages (e.g., Net Profit Margin of 12% vs. 8%).
• Strengths & Weaknesses: High ROE indicates better shareholder returns; high Debt-to-Equity suggests risk.
• Valuation Comparison: Lower P/E may indicate an undervalued stock.
• Liquidity & Solvency Check: Higher Current Ratio means better short-term financial stability.
• Operational Efficiency: Higher Inventory Turnover means better stock management.
• Growth Analysis: Higher EPS growth suggests stronger earnings potential.

Best Practices for Comparative Analysis

✅ Compare companies within the same industry (since different industries have different financial structures).
✅ Use multi-year trend analysis instead of relying on a single period.
✅ Consider market conditions & business models while comparing ratios.
✅ Adjust for accounting differences (some companies may follow different depreciation or inventory methods).

Trend analysis helps track a company’s financial performance over time, revealing patterns, strengths, and risks.

Key Benefits:

• Identifies Growth Trends: Shows revenue, profit, and efficiency improvements or declines.
• Detects Financial Stability: Consistently falling liquidity or rising debt signals financial stress.
• Improves Forecasting: Helps predict future performance based on historical data.
• Eliminates One-Time Anomalies: A single-year ratio may be misleading due to temporary factors.
• Enhances Decision-Making: Investors, lenders, and management can make informed long-term decisions.

Industry benchmarks provide standardized reference points to compare a company’s financial performance against peers.

Key Benefits:

• Performance Evaluation: Identifies if a company is above or below industry standards (e.g., ROE of 18% vs. industry average of 12%).
• Competitive Positioning: Helps assess market standing and efficiency compared to competitors.
• Risk Assessment: A higher-than-average Debt-to-Equity Ratio may indicate financial risk.
• Investment Decisions: Investors use benchmarks to identify undervalued or overvalued stocks.

While financial ratios are useful, they have certain limitations:

1. Industry & Company Differences

• Ratios vary across industries, making cross-industry comparisons ineffective.
• Different companies may have unique business models, impacting ratio interpretation.

2. Accounting Differences

• Different accounting policies (depreciation, inventory valuation) affect ratios, making comparisons misleading.
• Companies can manipulate financial statements, impacting ratio accuracy.

3. Ignores Qualitative Factors

• Ratios do not consider brand value, management quality, or market conditions.
• External factors like economic downturns or policy changes are not reflected.

4. Historical Data Reliance

• Ratios are based on past performance and may not indicate future trends.
• One-time events (e.g., acquisitions, economic crises) can distort results.

5. No Absolute Standards

• A "good" ratio varies by industry, company size, and economic conditions.
• High or low values may not always indicate good or bad performance.