Nowadays, investing in the stock market has become a popular avenue for many investors due to the potential for high returns. However, many investors face the problem of which stocks to pick.
Before picking any stocks, it is essential to analyze the company’s financial statements, such as the income statement, cash flow statement, and balance sheet. However, analyzing these financial statements in itself is a rigorous task because simply looking at numbers may not give you a clear idea about the company.
In such situations, ratio analysis becomes a convenient tool that helps you easily understand the company’s performance based on some ratios.
In this blog, we will explore ratio analysis, the different types of ratios, and how they are calculated. We will also see how ratio analysis is used in the stock market.
What is Ratio Analysis?
Ratio analysis is the cornerstone of a company’s financial analysis. It offers a systematic approach to evaluating a company’s performance and financial health. It involves calculating various ratios based on company financial statement information.
These ratios serve as invaluable metrics, providing insights into critical aspects of a company, such as operations, liquidity, profitability, and solvency.
By comparing these ratios over the period or against the industry’s benchmark, you can get a comprehensive view of the company’s strengths, weaknesses, and overall financial performance.
Categories of Ratio Analysis
In the ratio analysis of any company, the financial ratios can be classified into the following categories:
Liquidity Ratios
The liquidity ratio is one of the most commonly used metrics in ratio analysis, and it measures the company’s ability to repay its short-term liabilities or obligations. It includes the following ratios:
Current Ratio:
The current ratio measures the company’s potential to repay its current obligations using its current assets.
Current Ratio = Current Assets / Current Liabilities
Quick Ratio:
The quick ratio, or the Acid-test ratio, measures the company’s ability to forecast current or short-term liabilities and quick assets.
Quick Ratio = Current Assets - Inventories / Current Liabilities
Cash Ratio:
The cash ratio measures the company’s ability to repay short-term obligations using its most liquid current assets, namely cash and cash equivalents.
Cash ratio = Cash and Cash equivalents / Current Liabilities
Solvency Ratios
The solvency ratios measure the company’s ability to repay its long-term obligations. The primary purpose of this ratio is to check whether the company is generating sufficient cash flows to cover its liabilities. Some common solvency ratios include:
Debt to Asset Ratio:
This ratio indicates the company’s ability to pay debts by comparing its total debt to its assets and how much debt is against the assets. A lower ratio indicates less debt than assets, indicating a stronger financial position.
Debt to Asset Ratio = Total Liabilities / Total Assets
Debt to Equity Ratio:
This ratio also indicates the company’s proportions of total liabilities of the company in relation to total shareholders’ equity.
Debt to Equity Ratio = Total liabilities / Shareholders' equity
Interest coverage ratio:
The interest coverage ratio measures the company’s ability to pay its interest expenses for the debts taken.
Interest coverage ratio = Earning Before Interest and Taxes / Interest Expense
Provision Coverage Ratio (PCR):
This ratio is mainly used to evaluate banks’s stocks. It measures how much a bank’s provisions cover its loss arising due to nonperforming assets.
Typically, a PCR ratio above 70% is considered ideal for the banks.
PCR = Total Non-Performing Assets / Total Provisions for Loan Losses
Capital Adequacy Ratio (CAR):
This ratio indicates the bank’s capital adequacy in relation to its risk-weighted assets.
CAR = (Tier 1 Capital + Tier 2 Capital + Tier 3 Capital) / (Risk-Weighted Assets)
Profitability Ratios
The profitability ratio is another important financial metric used to evaluate a company’s ability to generate profits relative to its revenue, assets, equity, or capital employed. Simply put, it tells you how the company is utilizing its resources to generate profits.
Some of the profitability ratios include:
ROCE (%):
Return on capital employed or ROCE indicates how efficiently a company is generating profits in relation to its total capital employed.
ROCE (%) = EBIT / Capital Employed × 100
ROE (%):
Return on equity, or ROE, indicates how efficiently the company is generating profits relative to its shareholders’ equity.
ROE (%) = Net Income / Total Shareholder’s Equity × 100
ROA (%):
Return on assets, or ROA, indicates how much profit a company generates by using its total assets.
ROA (%) = Net Income / Total Assets × 100
EBIT Margin (%):
EBIT Margin (Earnings Before Interest and Taxes Margin) indicates the company’s profitability as a percentage of its revenue before deducting interest and taxes.
EBIT Margin = ( EBIT / Net Revenue ) × 100%
Net Margin (%):
Net margin refers to the percentage of revenue that finally translates into net profits after deducting all expenses.
Net Margin = (Net Income / Net Revenue) × 100
Operating Profit Margin:
Operating profit margin indicates the percentage of revenue that the company generates as operating profit after deducting operating expenses only.
Operating Profit Margin = (Operating Profit / Net Revenue) × 100
Cash Profit Margin (%):
Cash profit margin or operating cash flow margin represents the percentage of revenue that finally converts into cash profits.
Cash Profit Margin = ( Cash Profit or Cash Flow from Operating Activities / Net Revenue )×100%
Yield on Advances:
It is the percentage return that banks earn on their loan portfolio.
Yield on Advances = Interest Income / Avg. Advances
Yield on Investments:
It indicates the percentage of return that banks earn on their investments.
Yield on Investments = Annual Income / Investment Value
Interest Spread:
The interest spread represents the difference in interest rates between the interest rate offered on deposits and the interest rate charged on loans or debts by banks or other financial institutions.
Interest Spread = (Interest Income / Avg. Interest Earning Assets) – (Interest Expense / Avg. Interest Bearing Liabilities)
Net Interest Margin (NIM):
The net interest margin (%) indicates the difference between a bank’s or any financial entity’s interest revenue and the interest expense (paid to depositors) in proportion to the total assets generating interest.
NIM = (Investment Returns - Interest Expenses) / Average Earning Assets
PBIT Margin (%):
PBIT is used to assess a company’s operating profitability. It measures the percentage of revenue that remains after covering operating expenses, but before accounting for interest and tax expenses. This margin provides insight into the company’s operational efficiency and its ability to generate profits from its core business activities.
PBIT Margin (%) = [Revenue / PBIT ] × 100
Cost to Income Ratio:
Cost to Income Ratio is a financial metric commonly used to evaluate the efficiency of a company’s operations, particularly in the banking and financial services sector. It measures the proportion of operating expenses relative to the operating income, providing insights into how well a company is managing its costs in relation to its income.
Cost to Income Ratio=(Operating Income / Operating Expenses) × 100
Growth Ratios
The growth ratio tells you about the growth rate of various key metrics such as revenue, EBIT, Net profit, etc. It will give you an idea about whether the respective metrics have increased or decreased over the past year.
Revenue Growth (%):
It represents the percentage change in the net revenue as compared to the previous year’s revenue.
Revenue Growth (%) = (Current Year Revenue - Past Year Revenue) / Past Year Revenue
EBIT Growth (%):
This represents the percentage change in EBIT (Earnings Before Interest and Taxes) compared to the previous year’s EBIT.
EBIT Growth (%) = (Current Year EBIT - Past Year EBIT) / Past Year EBIT
Net Profit Growth (%):
It shows the percentage change in net income compared to the previous year’s net income.
Net Profit (%) = (Current Year Net Profit - Past Year Net Profit) / Past Year Net Profit
EPS Growth (%):
It represents the percentage change in EPS (Earnings Per Share) compared to the previous year’s EPS.
EPS Growth (%) = (Current Year EPS - Past Year EPS) / Past Year EPS
Operating Efficiency Ratios
The operating efficiency ratio or efficiency ratio tells about how well the company is using its resources to generate revenue and increase profits. Some of the operating efficiency ratios include:
Working Capital Days:
Working capital days indicate the total number of days that a company takes to convert its working capital into revenue or cash flow.
Working Capital Days = (Working Capital × 365) / Sales Revenue
Receivable Days:
This measures the average number of days a company takes to collect cash from its credit customers.
Receivable Days = (Average Accounts Receivable / Total Credit Sales) × 365
Inventory Days:
This evaluates how long a company takes to sell its inventory.
Inventory Days = (Average Inventory / Cost of Goods Sold) × 365.
Payable Days:
This indicates the average days a company takes to pay its vendor or suppliers.
Payable Days = (Accounts Payable / Cost of Goods Sold) × Number of Days.
Cash Conversion Cycle (CCC):
This measures the total cumulative time it takes the company to convert its investments into cash flow from sales.
CCC = Inventory Days + Receivable Days - Payable Days.
LDR / CDR / RDR / Accommodation Charge Notification:
Loans to Deposits Ratio (LDR) or Credit to Deposit Ratio (CDR) ratio is typically used to assess a bank’s liquidity by comparing its loans to its deposits.
LDR = (Total Loans / Total Deposits) × 100%
Leverage Ratio:
Leverage ratio is a financial metric used to evaluate a company’s debt levels relative to its equity or assets. It provides insights into the degree to which a company is using borrowed money (debt) to finance its operations and growth. Higher leverage ratios indicate higher levels of debt, which can imply greater financial risk but also the potential for higher returns.
Leverage Ratio = Total Debt / EBITDA
Valuation Ratios
The valuation ratios are one of the most commonly used ratios in stock market analysis. It helps you to analyze whether the company’s stock is undervalued or overvalued in the market.
Price-to-Earnings Ratio:
Price-to-earnings ratio or P/E ratio compares a company’s
Market price to its earnings per share. It gives you insight into how much investors are willing to pay for each dollar of earnings.
P/E Ratio = Market Price Per Share / Earnings Per Share
Price-to-book ratio:
P/B ratio compares a company’s market value to its book value, indicating whether a stock is overvalued or undervalued based on its assets.
Price-to-Book Ratio (P/B) = Market Capitalization / Book Value of Equity
Dividend Yield (%):
Dividend yield shows the percentage of a company’s stock price that is given to the stockholders as dividends.
Dividend Yield = Cash Dividend Per Share / Market Price Per Share
EV/EBITDA:
This ratio compares a company’s enterprise value relative to its earnings before interest, taxes, depreciation, and amortization.
EV/EBITDA = Enterprise Value / EBITDA
Market Value Ratios
Adjusted EPS (₹):
Adjusted EPS indicates the company’s per-share earnings after adjusting for extraordinary items or non-core profits and losses.
Cash EPS (₹):
Cash EPS is the company’s per-share earnings generated from operating activities.
Cash EPS = Operating Cash Flow / Diluted Shares Outstanding
Adjusted Book Value (₹):
Adjusted Book Value represents the company’s worth by removing non-operating assets and liabilities, such as goodwill and intangible assets, from its balance sheet, offering a clearer view of its true value.
Adjusted book value = Adjusted Asset - Adjusted Liability
Dividend Yield%:
Dividend yield indicates the ratio of dividend per share to the current market price of the stock.
Dividend Yield Ratio = Dividend Per Share/Market Value Per Share
Cash Flow per Share (₹):
Cash flow per share represents net cash flow generated per share.
Cash Flow per Share = (Operating Cash Flow - Preferred Dividends) / Total Common Shares Outstanding
Free Cash Flow per Share (₹):
Free cash flow per share represents free cash flow generated per share.
Free Cash Flow per Share = (Net Operating Profit after Taxes - Net Investment in Operating Capital) / Total Common Shares Outstanding
Basic EPS (₹):
Basic earnings per share indicates net income generated per the company’s outstanding share.
Basic EPS = [Net Income / Total Shares Outstanding] × 100
Diluted EPS (₹):
Diluted EPS is the extended version of EPS. It accounts not only for the existing outstanding shares but also includes the potential shares that could be created through instruments like warrants, convertible securities, and employee stock options. It reflects the net income available after considering the maximum possible share dilution.
Diluted EPS = (Net income - Preferred dividends) / (Weighted Avg Shares Outstanding + Dilutive Securities)
Dividend per share signifies the dividend distributed per outstanding share.
DPS = Total Dividends Paid Out in a Year/Outstanding Shares of the CompanyOR
DPS = Earnings Per Share × Dividend Payout Ratio
Book Value Per Share (BVPS) is a financial measure used in stock market analysis to determine the per-share value of a company based on its equity available to common shareholders. It represents the value of a company’s assets that shareholders would theoretically receive if the company were to liquidate.
BVPS = (Number of Outstanding Common Shares) / (Total Shareholders’ Equity − Preferred Equity)
Uses of Ratio in Stock Market Analysis
Ratio analysis serves various purposes in stock market analysis. Here are some of them:
- Financial Health Assessment: Ratios help you evaluate a company’s financial health, including its liquidity, stability, and profitability.
- Comparison: Ratios allow a comparison of a company’s performance with that of industry peers and benchmarks.
- Forecasting: Ratios also assist you in forecasting future performance and potential returns of the company by analyzing its growth ratios.
- Stock Valuation: It also helps you determine whether the company’s stock is overvalued, undervalued, or fairly valued based on the P/E Ratio or P/B ratio.
Conclusion
In conclusion, ratio analysis is a powerful tool that offers valuable insights into a company’s financial performance and future prospects. By analyzing different ratios, you gain a comprehensive view of the company’s liquidity, solvency, profitability, and growth. These findings enable comparison of a company’s stock with others or industry averages, aiding in investment decisions.
However, while ratio analysis provides key financial insights, it’s not the sole factor in evaluating stock performance. External factors such as market conditions, industry dynamics, and management style also impact a company’s stock. Therefore, a comprehensive evaluation of stock is crucial before making an investment decision.
FAQs for Ratio Analysis
Why is ratio analysis important?
Ratio analysis is important for evaluating a company’s performance. It gives valuable insights into the company’s financial health, efficiency in utilizing assets and potential returns for investors.
What Are the Uses of Ratio Analysis?
Ratio analysis can be used to evaluate the performance of the company in terms of profitability, liquidity, efficiency and solvency. It can also be used to cross-comparison between two companies, and forecast future performance.
What Are the Types of Ratio Analysis?
The types of ratio analysis include financial ratios, profitability ratios, growth ratios, solvency ratios, and valuation ratios.
What Is an Example of Ratio Analysis?
An example of ratio analysis includes comparing the current ratio of the company you are willing to invest in with its industry average to assess its liquidity position.
What are the key financial ratios for analyzing stocks?
Some of the key financial ratios for analyzing stocks include the P/E (Price-to-Earnings) ratio, Return on Equity, Return on Assets, Dividend-Price ratio, and Price-to-Book (P/B) Ratio.
Is the ratio analysis part of fundamental analysis?
Yes, ratio analysis is part of the fundamental analysis of the stock market.
