When investing in the stock market, it is important to understand a company’s financial or underlying strength. It can be done by analysing balance sheets, income, cash flow, and business statements. However, going through all the data points can take time for inexperienced investors. Another option is to focus on important financial ratios that help you understand the health of your business on the fly.
In general, ratio analysis is very important in investment decisions. It helps identify the performance of companies over the past few years, conducts comparative analysis between companies in the same industry, and helps identify the best companies within the industry for investment decisions.
Five Important Financial Ratios for Stock Analysis
There are several stock market metrics, but these important financial ratios are fundamental to stock analysis and should be familiarised with. Rather, it can give some guidance when trying to figure out the “value” of a stock.
It’s good to look at stock values from different angles. But in any case, you must ensure you have all the basics. These financial metrics are designed to do just that. Let’s get started.
1. Debt to Equity Ratio (D/E)
This ratio helps you understand how much external funding you need to run your business compared to your capital. A lower debt-to-equity (D/E) ratio is considered more favourable, while a higher ratio is considered riskier. As long as a heavily indebted company earns more than the interest it pays on external loans, it adds value to its shareholders.
However, if the interest cost is greater than the return on the amount borrowed, it can ultimately affect the company’s and its shareholders’ value. On the other hand, companies with low debt levels and low debt-to-equity ratios can have more room for future expansion due to the ease of raising funds.
You want to start a business but need a capital of Rs 2 lakh. You have 100,000 rupees and borrow the rest from a relative or bank. In this case, the debt-to-equity ratio is 1. It means that there is an equal amount of debt for every rupee in the capital. In general, a debt-to-equity ratio of less than one is considered safer.
2. Return on Equity
Return on Equity (ROE) is one of the most important financial ratios that help measure a company’s ability to generate returns from its shareholders’ investments. Mathematically, it is calculated by the below-mentioned formula.
RoE = Net Income/Total Shareholder’s Equity
Again, the higher the ratio, the better. This ratio also helps compare the profitability of companies in the same industry. A rising ROE shows that management is doing a good job of growing the company’s business while adding value to shareholders’ wealth. Analysts generally believe that a quality investment with a return on equity is in the 15-20% range.
3. Price Earnings Ratio (P/E)
This ratio is calculated by dividing the stock price by the company’s earnings per share (EPS). This ratio indicates how much the market is willing to pay for a stock based on past or future returns. The lower the ratio, the lower the valuation and vice versa. However, this ratio is not the only criterion for investment decisions. You should always compare P/E with other valuation parameters. Analysts believe that future P/E is more important than past P/E.
Companies that grow faster than average tend to have higher price/earnings ratios. A high P/E ratio indicates that investors are willing to pay a higher share price today for future growth expectations. For example, if a company is trading at 50x P/E versus the benchmark P/E of 30x, investors expect the company to outperform the market.
4. Operating Profit margin (OPM)
It is one of the important financial ratios that help you understand your company’s operational efficiency and pricing strategy. A high operating profit margin (OPM) indicates operational efficiency in procuring raw materials and transforming them into finished products. It measures a company’s profit after paying variable production costs such as wages and raw materials. You should always look for companies with increasing operating margins.
Operating margins are very important to investors and creditors as they indicate a company’s resilience and profitability. Simply put, it is calculated as operating profit divided by sales.
Let’s take an example Operation result of the company is 200,000 rupees, and the total sales of the company are 10,00,000 rupees. Dividing the operating profit by the total turnover gives an operating profit margin of 0.20, indicating that 0.80 Paise per rupee of turnover is used to cover variable costs. When comparing ratios, we recommend comparing companies in the same industry.
5. Asset turnover Ratio
This ratio measures how efficiently a company uses its assets to generate income or revenue. A high ratio means that a company generates more revenue than it spends on a particular asset. The results show how management is using their assets optimally. Note that comparisons should be made between companies in the same industry before proceeding. Asset turnover can be calculated by dividing sales by average total assets.
A detailed fundamental analysis of a company is essential, but these important financial ratios help provide a bird’s-eye view of a company’s financial health. It’s also important to remember that these ratios are dynamic. Therefore, it is important to recalculate quarterly (after the quarterly results announcement). The first step to becoming an expert investor is learning how to analyse a company’s fundamentals before investing in a stock.