How Do Financial Ratios Impact Investments and Stock Price

Impact of financial ratios on investment decisions

An average investor does some basic research about the company in which he/she wants to invest. For example the company’s past history, nature of business, future prospects, present performance and few other things. Equity market is dependent upon many things. If you want to earn good returns, you should have knowledge about certain crucial aspects and be vigilant. To be an informed investor, one needs to do thorough research about a lot of factors. One of those is financial ratios.

What are financial ratios?

Stock investing is like science. There are many financial indicators that help you analyse its sustainability. Reviewing the profit and loss account, balance sheet and cash flow is usually preferred before investing into a company’s stock. Reading the financial reports and interpreting them is not an easy task. All this information runs into several pages and often a layperson lacks the knowledge about the terminology used in those reports. Financial ratios make the whole process simple and they serve as the perfect performance indicators. 

A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise’s financial statements. They evaluate the overall financial condition of a company or other business units.

The most used financial ratios are profitability ratios, debt ratios, efficiency ratios, valuation ratios and so on. The relevance of these ratios depend upon the type of sector they are used into. Hence, in this article we shall focus on general as well as different sector based financial ratios which help an investor to arrive at a better decision. 

How do various financial ratios help in understanding a company’s performance?

Financial ratios make comparison possible between different time periods for the same company,a company with its industry average, and also with other companies. Financial analysts use these ratios to compare the strengths and weaknesses in different companies within the same sector. The market price of an equity share is often used to compare it with other shares traded in the market. Below is a list of financial ratios with their meaning. These being the most popular and widely used ratios are generally referred to often by its users. 

• Profitability ratios depict the ability of a company to earn from its sales or operations by efficiently using its assets/shareholder’s equity. Generation of profits and value for shareholders is useful when compared with the company’s own history or similar companies or industry average. 

The types of Profitability Ratios are as under:

1. Earnings per share-Ordinary shareholders find this ratio more useful. A higher ratio means a better company. Formula is: Net profit/Total number of shares outstanding.
2. Dividends per share-It represents the amount of dividend distributed by the company to its shareholders. High ratio shows that  the company has surplus cash. Formula to calculate this ratio is: Amount distributed to shareholders/Number of shares outstanding.
3. Gross Profit: The marginal profit of the company is represented by this ratio. A higher ratio means a more profitable company. Formula: Gross Profit/Sales*100

Where Gross Profit=Sales+Closing Stock-Opening stock-Purchases-Direct Expenses

4. Net Profit-It shows the overall profitability of a company after taking into account all the direct and indirect costs. A high ratio means a better company. Formula:Net Profit/Sales*100

Where Net profit=Gross Profit+Indirect Income-Indirect Expenses

5. Return on Equity-ROE represents profitability of equity funds invested by the company. It shows how much revenue is generated by using the funds of the shareholders. A company with a higher ratio should be preferred. Formula: Profit after tax/Net worth

Where Net worth=Equity share capital, reserves and surplus. 

6. Return on Capital Employed-This ratio measures percentage return in the company on the funds invested in the business by the owners. A good company has a higher ratio. Formula: Net Operating Profit/Capital Employed*100

Capital Employed=Equity Share Capital, Reserves and Surplus,Debentures and long term loans.

Or Total Assets-Total Liabilities

7. Return on Assets-ROA represents the earning per rupee of assets invested in the company. A higher ratio is a good indicator. Formula is Net Profit/Total Assets.

Profitability ratios are useful in almost all industries. Gross profit margin is one of the most used ratios. These ratios can be worked out for all manufacturing and trading companies.Retail businesses mostly experience seasonality. While comparing its profits with previous years, choose a similar quarter to compare results. 

• Liquidity ratios measure the availability of cash to pay debt. The current ratio shows a company’s ability to pay short-term obligations. It takes into account the total current assets relative to its total current liabilities. Other than the current ratio, quick ratios and cash ratios are used under this heading. These ratios are used to measure the company’s capability to meet its short term obligations. If the ratio is poor that means the company is not able to run its business efficiently and it cannot meet its short term obligations. 

1. Current Ratio-The companies whose current ratio is more than 1 should get priority over those below 1. This simply means that the current assets of the company are more than the current liabilities.
2. Quick Ratio-Another name for this ratio is Acid test ratio. It focuses mainly on the assets which are capable of paying the short term debts.

Quick ratio=(Current assets-Inventory)/Current liabilities.

Again a company with a ratio of more than 1 should be preferred.

• Efficiency ratios:To measure how efficiently a company uses its resources by investing in fixed/capital assets, this ratio is used. This ratio measures the ability of a business to utilise its assets and liabilities to generate sales. They are also used to judge the performance of one company with others in the same industry. Overall when these ratios are high it is implied that the management is efficiently running the business. The following ratios are used to measure the efficiency:

1. Inventory Turnover Ratio: This ratio is useful for those companies where inventories are found. It helps to measure the efficiency of cycling inventory. 

Inventory turnover ratio=(Costs of goods sold/Average inventory)

2. Average collection period: It is used to check the time the company takes to collect the payment owed by its receivables. 

Average collection period=(AR*Days)Credit sales

AR= Average amount of accounts receivable

Credit sales=Total amount of net credit sales in the period

A lower ratio shows that the time taken by the company to collect the receivables is less and is in interest of the company, as well as the investors. 

3. Asset Turnover Ratio: It shows how good a company is at using its assets to generate revenue. 

ATR=(Sales/Average total assets)

A higher ratio indicates better position of the company as it means more returns per rupee sent.

4. Accounts Payable Turnover: It is total purchases from suppliers divided by average payables. 

• Debt ratios:Debt/leverage/insolvency ratios are used to measure a company’s ability to meet its long term liabilities. 

1. Debt/Equity Ratio: It is a ratio showing the capital borrowed to the shareholder’s contribution. If the debt-equity ratio is less than one, the debts are less than the equity.The financial sector has one of the highest D/E ratios. D/E ratios higher than 2 are common for financial institutions. SInce banks borrow money and operate with a high degree of financial leverage they have higher D/E ratios. Capital-intensive industries also have higher D/E ratios like a large manufacturing company or the airline industry. 
2. Interest Coverage Ratio: It is used to measure how the company is able to manage its interest burden.

Interest coverage ratio=(EBIT/Interest expense)

EBIT=Earnings before interest and taxes. Thus, it shows the number of times a company can make the interest payments on its debt with EBIT. A higher ratio is a good indicator. The company can sustain the interest payment liability, timely payments, and good credit rating in case it wants to borrow more funds. Ideally, avoid the companies with less than 1 Interest coverage ratio.

• Valuation Ratios: They are useful for evaluating investment potential of a company as they put insight into the context of a company’s share price. Valuation ratios are used to compare the companies in the same sector. They highlight the relationship between the market value of a company or its equity based on a fundamental financial metric. The price that you are ready to pay for earnings or cash flow or any other financial metric is reflected in the respective ratio. They are particularly helpful to know about the share price valuation, its under and over valuation. The only limitation of valuation ratios is that they cannot be compared with the companies belonging to other sectors. 

1. Price to Sales Ratio: This ratio is used to compare companies in the same industry only. A lower PE ratio shows that the company is undervalued. 

P/S ratio=Price per share/Annual sales per share

2. Dividend yield-Dividend yield should be considered for a few years to know about the company. If the dividend is paid consistently and it is rising, it is taken as a good indicator. A new company might be paying a lesser dividend as compared to an established one. In addition to this, a new company may be retaining a part of its profits as reserves for future expansion. It all depends upon the investor’s interpretation and preference while making a choice to invest their money. 
3. Dividend Payout ratio-All the companies have a certain policy when it comes to distributing their profits. Mostly new ones and those who intend to enhance, keep a major part of their profits as reserves and give out lesser dividends. This ratio gives you the percentage of the profit distributed as dividends. If the ratio is very high, it could be riskier to invest in such a company. 

Dividend payout ratio=Dividend/Net Income

4. Price Earnings Ratio-As it shows the earnings of the company and payback period to the investors, it is extensively used by the investors everywhere around the globe. Each sector has an average PE ratio. A company which has a lower PE ratio is considered undervalued. The companies falling under the same sector can be compared with the average PE to know whether they have a higher or a lower PE ratio.

Price EarningRatio=:Market Price of Share/Earnings per share

5. Price to Book Value Ratio:The net asset value of any company is represented by its book value. It is given by deducting intangible assets and liabilities from total assets. 

P/B ratio=(market price per share/book value per share)

Again the ratio applicable to one industry cannot be compared with another industry.

6. PEG Ratio: This ratio is more useful as compared to PE ratio because the PE ratio ignores the company’s growth rate. The companies with a PEG ratio of more than one should be preferred. Those with less than 1 PEG are considered to be undervalued. PEG ratio is measured to know the value of a stock after taking into account the company’s earnings growth.

PEG ratio=(PE ratio/Projected annual growth in earnings)

7. EV/EBITDA:The companies with more debts can be valued effectively with the help of this ratio. This is a turnover valuation ratio.

EV=(Market capitalization+Debt-Cash)

EBITDA=Earnings before interest, tax, depreciation and amortization

A lower EV/EBITDA is considered good.

Industry Specific Ratios 

Over and above the ratios described above, there are a few industry specific ratios that help understand the results and returns of that particular industry/sector. Further, to analyse various industries an investor must know about the ratios to take into consideration. 

Banking: Both the customers and investors should look at the following ratios in case of a bank-

• Gross non-performing assets or NPAs: How much of a bank’s loans are in danger of not being repaid is measured by this ratio. A significantly high ratio means that the bank’s asset quality is poor. When interest is not paid on a loan for 3 month or more, it turns into an NPA.
• Net Non-performing assets throw more light on the conditions of loans. The bad loans have to be provided for in the books of account by the banks. Net NPA is nothing but all those bad loans. 
• Net interest Margin: This ratio shows the difference between interest earned by a bank on loans and interest paid by it on deposits. Low NIM is considered bad.
• Return on assets: The capability of a bank to earn returns by using its assets should be high in order to gain confidence of its investors. A lower RoA shows that the assets are not used fully. A negative RoA shows the bank is getting negative returns.
• Credit-deposit ratio:This shows the funds that are used for lending against the deposits the bank makes. If this ratio is high it means the bank is not doing good on the capital adequacy front. 
• Capital adequacy ratio: It is a ratio of a bank’s capital to its risk weighted assets and current liabilities.
• Provisioning coverage ratio: Banks set aside a certain amount of profits to provide against bad loans. A high ratio shows that the bank has taken care of all contingencies and it is not at a risk.

Financial Services The financial services sector is very important. Mostly it is governed by various stringent laws and other policies. Yet it is important to check two ratios which are: Price to book ratio and the Price to earnings ratio.  

The PB ratio is used by investors to compare the book value of a stock to its market value. To know about the intrinsic value of financial services firms, this ratio is important as a low PB ratio indicates stock undervaluation. PE ratio shows the stock price of a company to its earnings. A high ratio signals higher earnings for investors. 

Construction:The key financial ratios for the construction industry are Current ratio, Accounts receivable turnover,Total asset turnover, debt ratio, Equity ratio, Times interest Earned, Profit margin ratio, Gross margin ratio, Return on total assets. 

Accounts receivable turnover is calculated by taking net sales divided by average accounts receivables. It is very important that receivables are collected for the construction companies. How much they sell is not important. Rest all ratios are explained in the article.

Pharmaceuticals: Pay attention to financial ratios like profitability ratios(operating margin and net margin),Liquidity and Debt Coverage Ratios, Return on Equity. Pharma companies incur higher capital expenditures and research & development costs.The following ratio is also  important to understand:

• Return on Research Capital Ratio: Any pharma company should be viewed from the return it realizes from its R&D expenditures. This ratio is calculated by dividing the current year’s gross profit by the previous year’s total R&D expenditures. 

IT:An investor should analyse an IT company differently as often these companies seek to be acquired. Liquidity, profitability and financial leverage ratios should be taken into account. Current ratio and debt to equity ratios too are helpful to investors. Many tech companies are not profitable initially. Hence it is necessary to also consider their gross profit margin.

Retail business: Current ratio, Quick ratio, Gross profit margin, Inventory turnover, Return on assets, Interest coverage ratio, EBIT margin should be considered by the investors for retail business. 

Manufacturing companies: The other key financial ratios are inventory turnover ratio, maintenance cost to expenses and revenue per employee ratio. 

• If the inventory turnover is low, the company could be handling too much inventory. It can put it at greater risk for inventory obsolescence. 
• The equipment and machinery are used for the production process. Repairs and maintenance costs to total cost ratio should be studied. A low ratio means the company has new fixed assets or it replaces it quickly and the maintenance cost is kept low.
• Revenue per employee is calculated by dividing the total revenue of a manufacturing company by the number of employees. When two companies with the same capacity hire an unequal number of employees, one with more and the other with less, naturally the one with lesser number of employees gets more return per employee. Which proves that the former is overemployed and is not efficiently using its resources. 
• Total manufacturing costs per unit minus materials, Manufacturing costs to total expenses and Return on Net assets are other important ratios. 

Tourism and Hospitality:This industry includes hotels, events, tourist destinations etc. However, the companies under this heading cannot be compared very easily because of the presence of many subsectors. As an investor you can look at Liquidity ratios, Financial leverage ratios like debt to total assets ratio, Profitability ratios including both the gross and net profit margin ratios. 

Automobile:Key financial ratios for this industry are Debt to Equity ratio, Inventory turnover ratio, Return on equity ratio, Return on Capital employed and Return on Assets.

Telecommunication:For evaluating companies in this sector you have to use some unique parameters to understand their performance. They are average revenue per user, churn rate and subscriber growth. 

• Average Revenue Per User(ARPU)- It is calculated by dividing the total revenue for a period by the average number of users. It shows a company’s operational performance. Investors want to measure marginal profit and cost on a unit level since these companies are service providers. If the average revenue is higher, it is considered to be good.
• Churn Rate:It shows the number of subscribers who leave. This rate is measured on a quarterly or on annual basis. This rate is often used by the Internet providers,Telephone service providers, Cable and satellite TV providers. A higher churn rate means the company is struggling to earn returns. 
• Subscriber Growth:The companies in this sector have to grow their customer base. This rate shows the competitiveness of the company from the technological point of view. If the company uses the latest technology, the customers will be happy and more customers will be inclined to join. It is also known as net additions. 

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Krishna Rath is a SEBI Registered Investment Adviser, and since 2015 has been educating netizens on investments and insurance. Krishna is a fee only SEBI RIA and is Odisha's first SEBI RIA. With background in IT, Krishna is changing the advisory space with new innovations in AdvisoryTech.

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