The Significance of Financial Ratios For Analyzing A Company’s Balance Sheet

Significance of Financial Ratios

Financial ratios are the most significant tools in the field of finance. It explains the company’s current situation with a 360 degree financial image of it. When a combination of ratios is put together it becomes easy to spot the flaws in a company’s balance sheet. The ratios help in analysing a company, in making a report about the company and determining whether the company is good or not to invest into. Hence it allows an individual to make an informed decision on the company’s present and based on the historical data one can also assume the future possibilities as well.

Through financial ratios the work of a person downsizes in analysing a company. The ratios are a clear indication of the company’s situation. Hence it is no longer required to read the B/s (balance sheet) and C.F. (cash flow) statements of the company. Nowadays, ratio analysis is very important to make investment decisions. It shows the real position of a company in the form of some numbers.

Types of Financial Ratios

The ratios have been divided into various subgroups. They are :

  • Profitability Ratios
  • Liquidity Ratios
  • Solvency Ratios
  • Valuation Ratios

The profitability ratios are :

  1. Operating Margin
  2. Gross Margin
  3. Net profit Margin
  4. Return on Equity
  5. Operating Cash flow Margin
  6. Return on Assets
  7. EBITDA Margin
  8. Return on capital invested
  9. Return on Investments

The liquidity ratios are :

  1. Current ratio
  2. Quick Ratio
  3. Operating cash Flow Ratio
  4. Cash Ratio
  5. Receivables turnover
  6. Working capital Turnover
  7. Inventory Turnover
  8. Cash conversion ratio

The solvency ratios are :

  1. Debt to equity ratio
  2. Time interest earned ratio
  3. Net income to liabilities
  4. Interest coverage ratio
  5. Debt to total assets

The valuation ratios are :

  1. Price to cash flow ratio
  2. P/Bv ratio
  3. Price to sales ratio
  4. P/E ratio

Important Ratios

There are a lot of financial ratios. Out of all, there are some very important ratios which are mentioned below for referral :

  • Debt to equity ratio
  • P/E ratio
  • Price to book value
  • P/E growth ratio
  • Return On Equity
  • Current Ratio
  • Asset Turnover Ratio
  • Dividend Yield ratio
  • Operating profit margin ratio

Debt to Equity Ratio

It shows the amount of leverage a company has. This enables an investor to know about what is the company’s situation in terms of liquidity and in-house cash. It enables you to know how much money the company has in its pockets and how much money the company is borrowing in the form of debt. It is calculated by :

D/E ratio = Total liabilities/Total shareholder’s equity

If the company earns sufficiently well after paying its interest, the company’s profits would increase which will allow the company to reduce the debt in the long term. This would increase the company’s valuation and benefit the shareholders. However higher the debt, better to stay away from that company.

P/E Ratio

P/E means price to earnings ratio. It indicates the price of investment an investor has to make for getting one rupee return out of it. It is one of the most important factors in determining the price of the company. The stock price of any company equals to P/E * EPS (earning per share). P/E is always compared with industrial P/E so that the company’s performance can be reviewed in comparison to the other companies in the same segment. Ideal P/E is having the figure closer to the industrial P/E. Too little P/E indicates that the company is not performing well and and a significant high P/E indicates that the company is overvalued and it can go under the bus at any point of time.

P/E = Market price of share / EPS

Price to Book Value

P/BV is an indication of the company’s present financial condition. In other words it can be said if the company winds up its business then by selling all the assets and paying all the liabilities, the amount left is the Price to book value of the company. It helps in knowing the company’s actual worth and whether it is overvalued or undervalued in the market. A figure below 1 indicates that the company is undervalued. Hence we use assets and liabilities indicating the company’s present financial situation in this ratio.

P/BV = Stock price / Shareholder’s equity per share

P/E Growth Ratio

It indicates the relationship between price, earning and growth of the company. It explains how much price is to be paid for attaining a certain percentage of growth by the company. Hence higher the PEG ratio is worse for the company. The reason being the company has to spend more for attaining the growth percentage than before. Lower PEG ratio is an indication for a better company. The reason being the company’s expenses have been stable or decreased and it has still achieved growth.

PEG =    Price/Earnings

Annual EPS growth

Return On Equity

It determines how much the company is providing returns to the shareholders. Hence it tells the retutn rate of the company per quarter or per year. It shows how the company is utilizing the equity amount for growth and earning well from it. Higher the ROE better for the company. The real is it indicates that the company is utilizing the equity investment amount well and providing better returns to the shareholders.

ROE = Net income/ Total of shareholder’s equity

Current Ratio

Current ratio = Current assets / Current liabilities

It shows the ratio of current assets to current liabilities with the company. It is important as it shows how much debtors and creditors are there with the company. The more the ratio the better for the company. Let’s understand it technically. Debtors form the current asset side in the balance sheet and creditors are present under current liabilities. Now if the current ratio is more than 1, it means that company’s debts are less in comparison to the outstanding receipts. Hence it has a good balance between them. More current ratio is always better for the company as it shows the potential flow of funds into the company.

Asser Turnover Ratio

It indicates the company’s potential of generating revenue through its assets. Hence the higher the ratio the better the company’s ability to use its assets. Assets form a crucial part of the company’s B/s. They should provide companies with constant income. Hence a higher ratio indicates the method of asset utilization is going well.

However while calculating this ratio it is advised that the comparison should be made within the same industry. The reason is different industries use their assets in a different manner. Hence they have different ratios based on the segment of working.

Asset turnover ratio = Net sales or total revenue / Average Total assets

Dividend Yield Ratio

Dividend yield ratio is a sign of showing how much the company is paying dividend per share.

It indicates how much the company is providing dividend income to the shareholders. The dividend income is not necessary to be provided to the shareholders. But it is a sign of trust and consistency which the companies tend to maintain so that the shareholders keep investing in them.

Low valued companies never give away dividends. Also penny stocks and other debt ridden companies cannot afford it as giving dividend means making loss and the dividend income comes from profits only. The reason is dividend is a sign for the company’s appreciation towards shareholders for having faith and continuously investing into them.

Dividend Yield ratio = Annual dividend per share / Current share price

Operating Profit Margin Ratio

OPM = Operating profit / Net sales.

It shows how much the company has grip over its pricing. The reason is higher the margin better is the company’s costing as the company’s operating profits will rise only by two reasons if the sales increase or if the price decreases. If both these scenarios happen together this means the company is moving into the right direction. Hence meaning the company has a bright future as it has lower cost and better sales.




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