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Five Financial Ratios That All Stock Investors Should Understand

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Synopsis:

Ratios help investors make sense of the financial statements of companies. They enable investors to compare a company with its peers to assess its performance. Investors can also use ratios to see how a company has evolved over time. The top five financial ratios include the Price-to-Earnings (P/E) Ratio, Debt-to-Equity (D/E) Ratio, Return on Equity (ROE), Current Ratio, and Earnings Per Share (EPS). These ratios are vital whether you are a new or seasoned investor. However, you should keep in mind that these ratios are based on past data. Hence, they may not always help you estimate a company’s performance in the future.

Five Financial Ratios that All Stock Investors Should Understand

Whether you have just started trading online or are a seasoned trader, you should learn to use the top five financial ratios to analyse a company’s financials well. These ratios are the Price-to-Earnings (P/E) Ratio, Debt-to-Equity (D/E) Ratio, Return on Equity (ROE), Current Ratio, and Earnings Per Share (EPS).

Using these ratios, you can compare companies with their closest competitors to draw compelling insights. You can also perform a trend analysis using financial ratios to see how a company’s performance has evolved over time.

Importance of financial ratios in stock investing

Most numbers reported in the financial statements of a company do not reveal much on their own. It is only when we combine two or more numbers using financial ratios that we can draw insights into a company’s performance.

Let us take the case of the debt-to-equity (D/E) ratio. Suppose a company has Rs. 20 lakhs of liabilities. Should we be concerned about it or should we be satisfied with its performance? On its own, the liabilities number fails to convey anything about the company’s performance.

But let us say that the company has shareholders’ equity of Rs. 10 lakhs, then it has a D/E ratio of 2:1. This can be a good starting point for our financial ratio analysis.

In simple words, ratios help us make sense of complex data reported in financial statements and enable us to decide whether we should invest in a company or not.

Overview of the five key financial ratios

Price-to-Earnings (P/E) Ratio

  • Definition and formula: This ratio compares the price of a share with its earnings. It examines how much a shareholder has to pay to purchase a share for each rupee of earnings it generates.

Formula: Price of a Share / Earnings per Share

  • How to interpret the P/E ratio: When a stock has a higher P/E ratio than its closest competitors, it indicates that the stock’s price is high compared to its earnings-generating potential. Hence, such a stock can be called overvalued. Conversely, if a stock has a lower P/E ratio than its closest rivals, it could be that its price is low vis-à-vis its ability to generate profits and hence it is undervalued.

  • Case study: Using P/E ratio in investment decisions: Suppose A, B, and C are all FMCG stocks and are close competitors. The P/E ratio of A, B, and C is 10, 14, and 17, respectively. Based on this data, it seems that A is the cheapest stock and C is the most expensive stock. However, at times, the earnings of a company can get affected due to one-time factors, which can provide us with a misleading P/E ratio. Hence, you should adjust the earnings of A, B, and C to normalise them and then check the P/E ratio.

Debt-to-Equity (D/E) Ratio

  • Definition and formula: This ratio is a measure of a company’s financial leverage. It shows to what extent a company is using debt (or external sources) and not its own funds to finance its operations.

Formula: Liabilities of a company / Shareholders’ equity of a company

  • Significance of the D/E ratio in evaluating a company’s leverage: The D/E ratio tells us how efficiently a company is using debt to finance its growth and operations. If a company has a very high D/E ratio, it means its reliance on external funds is high. Besides, the company could also be under tremendous pressure to pay interest on the debt. However, if a company has an extremely low D/E ratio, it is perhaps too conservative in using debt to fuel its growth. As this ratio provides us with compelling insights, it is important to evaluate a company’s leverage.

  • Example: Assessing a company's financial health with the D/E ratio: Suppose a manufacturing company has a D/E ratio of 2:1. For each rupee of shareholders’ equity, it has two rupees of liabilities. This sounds alright because a D/E ratio of 2:1 is often seen in such companies. However, the company’s interest expenses are so high that it is incurring a loss. Then, we need to analyse why its interest expense is extremely high when its D/E ratio is not unusual. It could be that the interest rate in the market is high. Or, it could be that the lenders are willing to provide funds to the company only at a high rate. If that is the case, we need to know the reason why lenders are asking for a high interest rate.  

Return on Equity (ROE)

  • Definition and formula: ROE is a measure of a company’s profitability. It shows us how well a company uses its equity to generate a profit.

Formula: Net Profit of a Company / Shareholders’ Equity

  • Importance of ROE in measuring profitability: Equity shareholders are the ultimate owners of a company. Hence, it is important to assess whether a business is able to generate a reasonable ROE or not. If a business is not able to provide a sufficient return to its equity shareholders, they may think of liquidating it. Hence, ROE is one of the most important ratios from a profitability viewpoint.

  • Practical application: Comparing ROE among industry peers: Let us say that we have three close competitors from the IT industry - X, Y & Z. X has an ROE of 25%, Y has an ROE of 28%, and Z has an ROE of 32%. This shows that Z is able to generate a better return for its equity shareholders than X and Y. And, X is able to generate the lowest return of the three companies.

Current Ratio

  • Definition and formula: The current ratio is an indicator of a company’s short-term liquidity. It shows whether a company can pay its short-term obligations (which are due within one year) comfortably or not.

Formula: Current Assets / Current Liabilities

  • Relevance of the current ratio in assessing liquidity: If a company is not able to pay its short-term obligations by using its current assets, then it will face a liquidity crunch. It may have to borrow to pay its short-term obligations. However, since it is already facing a liquidity crunch, lenders may not provide it with funds. Hence, it may turn out to be a vicious circle. Therefore, the current ratio is extremely relevant.

  • Real-world scenario: Evaluating a company's short-term financial stability: Britannia Industries Ltd., one of the major manufacturers of bakery products in India, had total current assets amounting to Rs. 4,849 crores and total current liabilities amounting to Rs 4,084 crores as on March 31, 2024 based on its annual report uploaded at the Bombay Stock Exchange’s (BSE) website. Hence, its current ratio was around 1.2. Its current assets are a bit more than its current liabilities. Therefore, it can pay its short-term obligations easily using its current assets. Hence, it is not facing a liquidity issue.

Earnings Per Share (EPS)

  • Definition and formula: It is an indicator of a business's profitability. In simple words, EPS means how much profit is earned by each share of common stock. 

Formula: (Net Profit – Preferred Dividends) / Common Shares Outstanding

  • How EPS impacts stock prices: EPS is a measure of a company’s profit-generating ability. Hence, if a company’s EPS increases, its stock price should also increase. After all, shareholders will reward a company if it improves its ability to generate profits. However, if a company’s EPS falls, its share price is likely to fall.

  • Case study: Analysing a company's EPS trend over time: Suppose a company had an EPS of Rs. 10, 12, 20, 14, and 16 in Years 1, 2, 3, 4, & 5, respectively. Notice that its EPS suddenly jumps from Rs. 12 in Year 2 to Rs. 20 in Year 3. Then, EPS declines to Rs. 14 in Year 4. It seems that Year 3 is an aberration. Often companies report a one-time profit, for example, on account of the sale of an asset like land or shares. Such one-time items are unlikely to get repeated. Hence, you should remove one-time items from the earnings for all the years and then analyse the trend in a company’s EPS.

Conclusion

The five ratios discussed above can help investors analyse a company’s performance. More importantly, these ratios can help investors compare a business’s performance with its peers. Hence, they are extremely important if you are trading online. Ratios are at the core of financial analysis when we decide whether we should invest in a company or not. Hence, all investors should get a firm grip on ratios to make better investment decisions.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

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Frequently Asked Questions

What are financial ratios and why are they important for stock investors?

Answer Field

While trading online, you can use financial ratios to examine the financial statements of companies. They can help us analyse several aspects of a business, including its profitability, liquidity, solvency, efficiency, etc.

How can investors use these financial ratios?

Answer Field

Investors can compare the ratios of one company with its closest competitors to assess how it is performing vis-à-vis its rivals. They can also see how a company’s ratios have changed over a period of time by conducting a trend analysis.

What is the Price-to-Earnings (P/E) Ratio?

Answer Field

A ratio that compares the stock price of a company with its earnings per share is called the price-to-earnings (P/E) ratio. It helps us determine whether a stock is over or undervalued.

What is the Debt-to-Equity (D/E) Ratio?

Answer Field

This ratio compares a company’s liabilities with its shareholders’ equity. It helps us determine whether a company is over or under-leveraged.

What is the Return on Equity (ROE) Ratio?

Answer Field

This ratio compares a company’s net profit with its shareholders’ equity. It enables us to examine whether a company is generating sufficient returns for its equity shareholders.

What is the Current Ratio?

Answer Field

This ratio tells us whether a company can pay its short-term obligations (those falling due within one year) comfortably. For this, we divide a company’s current assets by its current liabilities.

What is the Dividend Yield Ratio?

Answer Field

This ratio compares a company’s annual dividends with its current stock price. It tells investors how much return they are likely to generate from dividends alone by investing in a company.

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