Its time to revamp the Financial basics..
In-depth understanding of Important Financial Formula and Ratios
Twitter: shuchi_nahar
What are Financial Ratios?
Financial ratios are created with the use of numerical
values taken from financial statements to gain meaningful information about a
company. The numbers found on a company’s financial statements – balance sheet,
income statement, and cash flow statement – are used to perform quantitatively
analysis and assess a company’s liquidity, leverage, growth, margins, profitability,
rates of return, valuation, and more.
ROA tells an investor how much Profit or Return a company generated for each Rupee of Assets.
The formula for Return on Assets
ROA = Earnings/Assets
Alternatively, this can also be expressed as ROA = (Earnings/Sales) x (Sales/Assets), or
Formula Dissection
ROA = Net Margin x Asset Turnover
The first component of Return on Assets is simply Net Margin or Net Income divided by Sales.
It tells us how much of each Rupee of Sales a company keeps as Earnings, after paying all the costs of doing business.
The second component is Asset Turnover or Sales divided by Assets, which tells us roughly how efficient the firm is at generating Revenue for each Rupee of Assets.
Multiply these two, and we have the formula for Return on Assets.
Practical Implications:
ROA helps us understand that there are two routes to obtain excellent operational profitability.
The company can charge high prices for its products (high margins) or it can turn over its assets quickly.
When using ROA as a comparative measure it is best to compare it against a firm's previous ROA numbers or the ROA of a similar company. ROA for public companies can vary substantially and will be highly dependent on the industry.
Calculating Return on Assets
Calculate ROA by simply dividing Profit after Tax (annual earnings) by the Average of Total Assets.
Calculate Average Total Assets for any fiscal period by adding Total Assets for the fiscal and the previous fiscal and divide by two.
Profit after Tax can be taken from the Profit and Loss Statement from the firm's Annual Reports.
The firm's Total Assets can be found in the Balance Sheet filed in the firm's Annual Reports.
Annual Reports can usually be found at the firm's website or from the SEBI EDIFAR database.
Total Assets refer to all the resources a company has at its disposal - the shareholder's capital plus short and long-term borrowed funds.
Rough benchmarks for analyzing a firm's ROA
All things being equal, the more asset-intensive a business, the more money must be reinvested into it to continue generating earnings.
This is a bad thing.
If a company has a ROA of 20%, it means that the company earned Rs. 20 for each Rs. 100 in assets.
As a general rule, anything below 5% is very asset-heavy [manufacturing, railroads], anything above 20% is asset-light [advertising firms, software companies].
Return on Equity (ROE)
Return on Equity (ROE) is a great overall measure of a company's profitability because it measures the efficiency with which a company uses shareholders' equity.
Think of it as measuring profits per rupee of shareholders' capital.
As a rule of thumb, firms that are consistently able to post ROEs above 20% are generating solid returns on shareholders' money, which means they are likely to have economic moats.
Significantly, Return on Equity can tell us more than just the efficiency of using shareholders capital.
ROE provides a direct peek into how well a firm balances - profitability, asset turnover and financial leverage - to provide decent returns on shareholders' equity.
This is because there are only three levers for boosting ROE - Net Margin, Asset Turnover and Financial Leverage. Let's see why this is so by examining the return on equity formula.
Formula Dissection
ROE = Earnings/Shareholders' Equity
Alternatively expressed as
ROE = (Earnings/Sales) x (Sales/Assets) x (Assets/Shareholders' Equity), or
ROE = Net Margin x Asset Turnover x Financial Leverage
Practical Implications:
So we have three levers that can boost Return on equity -net margins, asset turnover, and financial leverage. For example,
A firm can have only so-so margins and modest levels of financial leverage, but it could do a great job with asset turnover (e.g. a well-run discount retailer).
Companies with high asset turnover are extremely efficient at extracting more rupees of revenue for each rupee invested in hard assets.
A firm might have asset turns only middling, and the firm might not have much leverage, but say it has great profit margins (e.g. a luxury goods company) - that would make for decent ROEs.
Finally, a firm can also boost its ROE to respectable territory by taking on good-size amounts of leverage (e.g mature firms such as Utilities).
Calculating Return on Equity
Return on Equity is simply calculated by dividing Profit after Tax (annual earnings) divided by Shareholders' Equity.
Profit after Tax can be taken from the Profit and Loss Statement from the firm's Annual Reports.
The Shareholders Equity can be found in the Balance Sheet filed in the firm's Annual Reports.
Shareholders Equity is simply the difference between Total Assets and Total Liabilities - the assets that the business has generated.
Rough benchmarks for analyzing a stock's ROE
In general, any non-financial firm that can generate consistent ROEs above 15 percent without excessive leverage is at least worth investigating.
And if you can find a company with the potential for consistent ROEs over 30%, there's a good chance you are really onto something.
Two Caveats when using ROE to analyze stocks
Banks always have enormous financial leverage ratios, so don't be scared off by a leverage ratio that looks high relative to a non-bank.
Since banks' leverage is always so high, you want to raise the bar for financial firms - look for consistent ROEs above 18% or so.
There are firms with ROEs that look too good to be true because they are usually just that.
ROEs above 50% or so are often meaningless because they have probably been distorted by the firm's financial structure.
Firms that have been recently spun off from parent firms, companies that have bought back much of their shares, and companies that have taken massive charges often have very skewed ROEs because their Equity base is depressed.
When you see an ROE over 50%, check to see if the company has any of these above-mentioned characteristics.
Return on Invested Capital (ROIC)
Return on Invested Capital (ROIC) is a sophisticated way of analyzing a stock for return on Capital that adjusts for some peculiarities of ROA and ROE.
It is worth knowing how to interpret it because it’s overall a better measure of profitability than ROA and ROE.
Essentially ROIC improves on ROA and ROE because it puts debt and equity financing on an equal footing.
It removes the debt-related distortion that can make highly leveraged companies look very profitable when using ROE.
It also uses a different definition of Profits than ROE and ROA, both of which use Net Profits.
ROIC uses Operating Profits after taxes, but before interest expenses (PBIT)
Again, the goal is to remove any effects caused by a company's financing decisions -does it use debt or equity? So that we can focus as closely as possible on the profitability of the core business.
The true operating performance of a firm is best measured by ROIC, which measures the return on all capital invested in the firm regardless of the source of the capital.
ROIC =Net Operating Profit After Taxes (NOPAT)/Invested Capital
Invested Capital =Total Assets - Non-Interest bearing Current Liabilities - Free Cash Flow
(Non-interest bearing current liabilities usually are Accounts Payable and other Current Assets)
You may also want to subtract Goodwill if it's a large percentage of Assets.
Practical Implications:
Interpretation of ROIC is same as that of ROA and ROE - a higher Return on Invested Capital is preferable to a lower one!
Rough benchmarks for analyzing a firm's ROIC
In general, any non-financial firm that can generate consistent ROICs above 15 percent is at least worth investigating.
As of mid-2008, only about 10% of the non-financial firms listed in NSE were able to post an ROIC above 15% for each of the past 5 years, so you can see how tough it is to post this kind of performance.
And if you can find a company with consistent ROICs over 30%, there's a good chance you are really onto something.
Free Cash Flow (FCF)
Free cash flow (FCF) is calculated by subtracting Capital expenditures from Operating cash flow.
Cash Flow from Operations measures how much cash a company generates.
It is the true touchstone of corporate value creation because it shows how much cash a company is generating from year to year.
As useful as the Cash Flow statement is, it does not take into account the money that a firm has to spend on maintaining and expanding its business.
To do this, we need to subtract Capital Expenditures, which is money used to buy fixed assets.
Free Cash Flow Formula
Free Cash Flow = Cash Flow from Operations - Capital Expenditure
Free Cash Flow enables us to separate out businesses that are net users of Capital - ones that spend more than they take in- from businesses that are net producers of Capital because it is only that excess cash that really belongs to shareholders.
Free Cash Flow is sometimes referred to as "Owners Earnings" because that's exactly what it is: the amount of money the owner of a company could withdraw from the treasury without harming the company's ongoing business.
A firm that generates a great deal of FCF can do all sorts of things with the money - save it for future investment opportunities, use it for acquisitions, buy back shares, and so forth.
Positive FCF gives financial flexibility because the firm isn't relying on the capital markets to fund its expansion.
Firms that have negative FCF have to take out loans or sell additional shares to keep things going, and can thus become a risky proposition if the market becomes unsettled at a critical time for the company.
Most analysts myopically focus on earnings while ignoring the real cash that a firm generates.
While earnings can often be clouded by accounting tricks, it's much tougher to fake cash flow.
For this reason, seasoned investors believe that FCF gives a much clearer view of the ability to generate cash (and thus profits).
Practical Implications:
Rough benchmarks for analyzing a firm's Free Cash Flow.
As with ROE, it’s tough to generalize how much FCF is enough.
However, it is reasonable to say that any firm that is able to convert more than 10% of Sales to FCF (just divide FCF by Sales to get this percentage) is doing a solid job at generating excess Cash.
Using Free Cash Flow ratio while analyzing stocks
Positive FCF companies will always have low levels of business risk than those with negative FCF.
It's also extremely useful to draw a direct correlation between FCF and RoE.
One must look for companies with high FCF coupled with high RoEs, this is the sweet spot - excess cash and the ability to earn a high return on it.
Companies with these characteristics tend to be the cream of the crop and have a low level of business risk.
Negative FCF is not necessarily a bad thing.
Because you can always find companies that are re-investing all of their cash in business expansion but are still able to generate a high RoE.
These firms have profitable reinvestment opportunities, and they should be spending all the cash they generate on expansion.
These expansion efforts may pay off in the form of fat profits in the future. A good example in the India Stock market is Bharti Airtel.
Still, one must not give too much importance to FCF while stock picking - especially multi-bagger prospects, except to check that the trend is improving.
For this kind of company in their early growth stages with nice ROE levels, I rather check that Operating Cash Flow should be positive and increasing.
If Operating Cash Flow is negative and/or shows a declining trend over a number of years, that's a warning sign that one must think about unloading their position in the stock.
Financial Leverage
Financial Leverage = Assets /Shareholders' Equity
Think of it like a Mortgage - a homebuyer who puts Rs. 200,000 down on a Rs. 1,000,000 house has a financial leverage ratio of 5.
For every Rupee in Equity, the buyer has Rs. 5 in assets.
The same holds true for companies. In 2008, a retailer like Trent has a financial leverage ratio of 2.1, meaning that for every Rupee in equity, the firm has Rs. 2.1 in total assets. (It borrowed the other Rs. 1.1.)
Financial Leverage is something you need to watch carefully.
As with any kind of debt, a judicious amount can boost returns, but too much can lead to disaster.
Look at the kind of business a firm is in.
If it's fairly steady, a company can probably take on large amounts of debt without too much risk because there's only a small chance of the business falling off a cliff and the company being caught short when bondholders demand their interest payments.
On the flip side, be very wary of a high financial leverage ratio if a company's business is cyclical or volatile.
Because interest payments are fixed, the company has to pay them whether business is good or bad.
ROA helps us understand that there are two routes to obtain excellent operational profitability.
The company can charge high prices for its products (high margins) or it can turn over its assets quickly.
When using ROA as a comparative measure it is best to compare it against a firm's previous ROA numbers or the ROA of a similar company. ROA for public companies can vary substantially and will be highly dependent on the industry.
Calculating Return on Assets
Calculate ROA by simply dividing Profit after Tax (annual earnings) by the Average of Total Assets.
Calculate Average Total Assets for any fiscal period by adding Total Assets for the fiscal and the previous fiscal and divide by two.
Profit after Tax can be taken from the Profit and Loss Statement from the firm's Annual Reports.
The firm's Total Assets can be found in the Balance Sheet filed in the firm's Annual Reports.
Annual Reports can usually be found at the firm's website or from the SEBI EDIFAR database.
Total Assets refer to all the resources a company has at its disposal - the shareholder's capital plus short and long-term borrowed funds.
Rough benchmarks for analyzing a firm's ROA
All things being equal, the more asset-intensive a business, the more money must be reinvested into it to continue generating earnings.
This is a bad thing.
If a company has a ROA of 20%, it means that the company earned Rs. 20 for each Rs. 100 in assets.
As a general rule, anything below 5% is very asset-heavy [manufacturing, railroads], anything above 20% is asset-light [advertising firms, software companies].
Return on Equity (ROE)
Return on Equity (ROE) is a great overall measure of a company's profitability because it measures the efficiency with which a company uses shareholders' equity.
Think of it as measuring profits per rupee of shareholders' capital.
As a rule of thumb, firms that are consistently able to post ROEs above 20% are generating solid returns on shareholders' money, which means they are likely to have economic moats.
Significantly, Return on Equity can tell us more than just the efficiency of using shareholders capital.
ROE provides a direct peek into how well a firm balances - profitability, asset turnover and financial leverage - to provide decent returns on shareholders' equity.
This is because there are only three levers for boosting ROE - Net Margin, Asset Turnover and Financial Leverage. Let's see why this is so by examining the return on equity formula.
Formula Dissection
ROE = Earnings/Shareholders' Equity
Alternatively expressed as
ROE = (Earnings/Sales) x (Sales/Assets) x (Assets/Shareholders' Equity), or
ROE = Net Margin x Asset Turnover x Financial Leverage
Practical Implications:
So we have three levers that can boost Return on equity -net margins, asset turnover, and financial leverage. For example,
A firm can have only so-so margins and modest levels of financial leverage, but it could do a great job with asset turnover (e.g. a well-run discount retailer).
Companies with high asset turnover are extremely efficient at extracting more rupees of revenue for each rupee invested in hard assets.
A firm might have asset turns only middling, and the firm might not have much leverage, but say it has great profit margins (e.g. a luxury goods company) - that would make for decent ROEs.
Finally, a firm can also boost its ROE to respectable territory by taking on good-size amounts of leverage (e.g mature firms such as Utilities).
Calculating Return on Equity
Return on Equity is simply calculated by dividing Profit after Tax (annual earnings) divided by Shareholders' Equity.
Profit after Tax can be taken from the Profit and Loss Statement from the firm's Annual Reports.
The Shareholders Equity can be found in the Balance Sheet filed in the firm's Annual Reports.
Shareholders Equity is simply the difference between Total Assets and Total Liabilities - the assets that the business has generated.
Rough benchmarks for analyzing a stock's ROE
In general, any non-financial firm that can generate consistent ROEs above 15 percent without excessive leverage is at least worth investigating.
And if you can find a company with the potential for consistent ROEs over 30%, there's a good chance you are really onto something.
Two Caveats when using ROE to analyze stocks
Banks always have enormous financial leverage ratios, so don't be scared off by a leverage ratio that looks high relative to a non-bank.
Since banks' leverage is always so high, you want to raise the bar for financial firms - look for consistent ROEs above 18% or so.
There are firms with ROEs that look too good to be true because they are usually just that.
ROEs above 50% or so are often meaningless because they have probably been distorted by the firm's financial structure.
Firms that have been recently spun off from parent firms, companies that have bought back much of their shares, and companies that have taken massive charges often have very skewed ROEs because their Equity base is depressed.
When you see an ROE over 50%, check to see if the company has any of these above-mentioned characteristics.
Return on Invested Capital (ROIC)
Return on Invested Capital (ROIC) is a sophisticated way of analyzing a stock for return on Capital that adjusts for some peculiarities of ROA and ROE.
It is worth knowing how to interpret it because it’s overall a better measure of profitability than ROA and ROE.
Essentially ROIC improves on ROA and ROE because it puts debt and equity financing on an equal footing.
It removes the debt-related distortion that can make highly leveraged companies look very profitable when using ROE.
It also uses a different definition of Profits than ROE and ROA, both of which use Net Profits.
ROIC uses Operating Profits after taxes, but before interest expenses (PBIT)
Again, the goal is to remove any effects caused by a company's financing decisions -does it use debt or equity? So that we can focus as closely as possible on the profitability of the core business.
The true operating performance of a firm is best measured by ROIC, which measures the return on all capital invested in the firm regardless of the source of the capital.
ROIC =Net Operating Profit After Taxes (NOPAT)/Invested Capital
Invested Capital =Total Assets - Non-Interest bearing Current Liabilities - Free Cash Flow
(Non-interest bearing current liabilities usually are Accounts Payable and other Current Assets)
You may also want to subtract Goodwill if it's a large percentage of Assets.
Practical Implications:
Interpretation of ROIC is same as that of ROA and ROE - a higher Return on Invested Capital is preferable to a lower one!
Rough benchmarks for analyzing a firm's ROIC
In general, any non-financial firm that can generate consistent ROICs above 15 percent is at least worth investigating.
As of mid-2008, only about 10% of the non-financial firms listed in NSE were able to post an ROIC above 15% for each of the past 5 years, so you can see how tough it is to post this kind of performance.
And if you can find a company with consistent ROICs over 30%, there's a good chance you are really onto something.
Free Cash Flow (FCF)
Free cash flow (FCF) is calculated by subtracting Capital expenditures from Operating cash flow.
Cash Flow from Operations measures how much cash a company generates.
It is the true touchstone of corporate value creation because it shows how much cash a company is generating from year to year.
As useful as the Cash Flow statement is, it does not take into account the money that a firm has to spend on maintaining and expanding its business.
To do this, we need to subtract Capital Expenditures, which is money used to buy fixed assets.
Free Cash Flow Formula
Free Cash Flow = Cash Flow from Operations - Capital Expenditure
Free Cash Flow enables us to separate out businesses that are net users of Capital - ones that spend more than they take in- from businesses that are net producers of Capital because it is only that excess cash that really belongs to shareholders.
Free Cash Flow is sometimes referred to as "Owners Earnings" because that's exactly what it is: the amount of money the owner of a company could withdraw from the treasury without harming the company's ongoing business.
A firm that generates a great deal of FCF can do all sorts of things with the money - save it for future investment opportunities, use it for acquisitions, buy back shares, and so forth.
Positive FCF gives financial flexibility because the firm isn't relying on the capital markets to fund its expansion.
Firms that have negative FCF have to take out loans or sell additional shares to keep things going, and can thus become a risky proposition if the market becomes unsettled at a critical time for the company.
Most analysts myopically focus on earnings while ignoring the real cash that a firm generates.
While earnings can often be clouded by accounting tricks, it's much tougher to fake cash flow.
For this reason, seasoned investors believe that FCF gives a much clearer view of the ability to generate cash (and thus profits).
Practical Implications:
Rough benchmarks for analyzing a firm's Free Cash Flow.
As with ROE, it’s tough to generalize how much FCF is enough.
However, it is reasonable to say that any firm that is able to convert more than 10% of Sales to FCF (just divide FCF by Sales to get this percentage) is doing a solid job at generating excess Cash.
Using Free Cash Flow ratio while analyzing stocks
Positive FCF companies will always have low levels of business risk than those with negative FCF.
It's also extremely useful to draw a direct correlation between FCF and RoE.
One must look for companies with high FCF coupled with high RoEs, this is the sweet spot - excess cash and the ability to earn a high return on it.
Companies with these characteristics tend to be the cream of the crop and have a low level of business risk.
Negative FCF is not necessarily a bad thing.
Because you can always find companies that are re-investing all of their cash in business expansion but are still able to generate a high RoE.
These firms have profitable reinvestment opportunities, and they should be spending all the cash they generate on expansion.
These expansion efforts may pay off in the form of fat profits in the future. A good example in the India Stock market is Bharti Airtel.
Still, one must not give too much importance to FCF while stock picking - especially multi-bagger prospects, except to check that the trend is improving.
For this kind of company in their early growth stages with nice ROE levels, I rather check that Operating Cash Flow should be positive and increasing.
If Operating Cash Flow is negative and/or shows a declining trend over a number of years, that's a warning sign that one must think about unloading their position in the stock.
Financial Leverage
Financial Leverage = Assets /Shareholders' Equity
Think of it like a Mortgage - a homebuyer who puts Rs. 200,000 down on a Rs. 1,000,000 house has a financial leverage ratio of 5.
For every Rupee in Equity, the buyer has Rs. 5 in assets.
The same holds true for companies. In 2008, a retailer like Trent has a financial leverage ratio of 2.1, meaning that for every Rupee in equity, the firm has Rs. 2.1 in total assets. (It borrowed the other Rs. 1.1.)
Financial Leverage is something you need to watch carefully.
As with any kind of debt, a judicious amount can boost returns, but too much can lead to disaster.
Look at the kind of business a firm is in.
If it's fairly steady, a company can probably take on large amounts of debt without too much risk because there's only a small chance of the business falling off a cliff and the company being caught short when bondholders demand their interest payments.
On the flip side, be very wary of a high financial leverage ratio if a company's business is cyclical or volatile.
Because interest payments are fixed, the company has to pay them whether business is good or bad.
Practical Implications:
Calculating Financial Leverage
Return on Equity is simply calculated by dividing Total Assets by Shareholders' Equity.
Shareholders Equity is simply the difference between Total Assets and Total Liabilities - the assets that the business has generated.
Shareholder equity is an accounting term that represents the assets created by the retained earnings of the business and the paid-in capital of the owners.
Total Assets is simply all the property owned by a company which includes current assets; fixed assets such as buildings, plant, and machinery, and other assets such as licenses and goodwill.
Rough benchmarks for analyzing a firm's Financial Leverage
A financial leverage ratio of 2.1 is fairly conservative, even for a fast-growing retailer.
It’s when we see ratios of 4, 5, or more that companies start to get really risky.
However, financial firms and banks have a much larger asset base relative to equity.
The average bank has a financial leverage ratio in the range of 12 to 1 or so, as compared to 2-to-1 or 3-to-1 for the average company.
Debt to Equity Ratio
A high debt-equity ratio for a firm indicates it has been aggressively financing its growth with debt.
Due to the additional interest expenses that have to be borne by the firm, this can result in volatile earnings.
A firm could potentially generate more earnings if a lot of debt is used to finance increased operations (high debt to equity) than it would have if it did not have access to this external financing.
Shareholders would benefit if this resulted in increased earnings by an amount greater than the debt cost (interest).
However, the cost of this debt financing may become too much for the company to handle, especially if earnings are cyclical and volatile, and outweigh the return that the company generates on the debt.
The debt-equity ratio also varies depending on the industry in which a firm operates.
For example, capital-intensive industries such as auto manufacturing tend to have a debt-equity ratio above 2, while software companies usually have a debt-equity ratio of under 0.5.
Calculating Debt to Equity
Debt to Equity Ratio= Long-Term Debt/Shareholders' Equity
Debt to Equity is simply calculated by dividing Total Debt (long-term debt is usually not reported separately in Annual Reports of Indian companies) divided by Shareholders' Equity.
Both Total Debt (sum up secured and unsecured loans) and Shareholders Equity can be found in the Balance Sheet filed in the firm's Annual Reports.
Shareholders Equity is simply the difference between Total Assets and Total Liabilities - the assets that the business has generated.
Rough benchmarks for analyzing a stock's Debt to Equity
The lower the better. Companies with Debt to equity less than 1 are conservatively financed.
Current Ratio
Current Ratio = Current Assets/Current Liabilities
Calculating Current Ratio
The current Ratio is simply calculated by dividing Current Assets divided by Current Liabilities.
Both Current Assets and Current Liabilities can be found in the Balance Sheet filed in the firm's Annual Reports.
Current Assets are those likely to be used up or converted into cash within one business cycle, usually defined as one year. Liabilities, similarly are those that have to be paid within a period of one year.
Rough benchmarks for evaluating a stock's Current Ratio
As a very general rule, a current ratio of 1.5 or more means the firm should be able to meet operating needs without much trouble.
However, when you find a company with current ratios of 3 or 4, you may want to be concerned.
A number this high might also mean that management has so much cash on hand, they may be doing a poor job of investing it.
It is always useful to compare companies within the same industry, therefore, to get a better picture.
Unfortunately, some current assets - such as Inventories - may be worth less than their value on the Balance Sheet.
Imagine trying to sell old PCs or last year's fashions to generate cash - you would be unlikely to receive anything close to what you paid for them.
If you see ratios around or below 1, should only be for companies that have inventories that can immediately be converted into cash (e.g. McDonalds).
If this is not the case and a company's number is low, that would be cause for concern.
Because of the generally illiquid nature of inventories, there's an even more conservative test of a company's liquidity, the Quick Ratio
Quick Ratio
The Quick Ratio is a more conservative test of a company's liquidity than the Current Ratio
We have learned that a current ratio of 1.5 or more means the firm should be able to meet operating needs without much trouble.
Unfortunately, some current assets - such as inventories - may be worth less than their value on the balance sheet.
Imagine trying to sell old PCs or last year's fashions to generate cash - you would be unlikely to receive anything close to what you paid for them.
Practical Implications:
Quick Ratio formula
Quick Ratio = (Current assets - Inventories)/Liabilities
In the event that short-term obligations need to be paid off immediately, there are situations in which the current ratio would overestimate a company's short-term financial strength.
By taking inventories out of the equation, Quick Ratio lets us find out if a company has sufficient liquid assets to meet its short-term operating needs.
It is especially useful for manufacturing firms and for retailers because both of these types of firms tend to have a lot of their cash tied up in inventories.
Calculating Quick Ratio
Quick Ratio is simply calculated by subtracting Inventories from Current Assets and dividing the result by Current Liabilities.
Inventories, Current Assets and Current Liabilities can be found in the Balance Sheet filed in the firm's Annual Reports.
Current Assets are those likely to be used up or converted into cash within one business cycle, usually defined as one year. Liabilities, similarly are those that have to be paid within a period of one year.
There are several types of inventories, including raw materials that have not yet been made into a finished product, partially finished products, spare parts, and finished products that have not yet been sold.
Rough benchmarks for analyzing a stock's Quick Ratio
In general, a quick ratio higher than 1.0 puts a company in fine shape but always looks to other firms in the same industry to be sure.
Price- Earnings (PE) Ratio
It is the most popular valuation measure, the Price to Earnings ratio or the PE ratio.
The nice thing about P/E is that accounting earnings are a much better proxy for cash flow than sales, and they are more up-to-date than book value.
Moreover, earnings per share results (and estimates) are easily available from just about any financial data source imaginable, so it’s an easy ratio to calculate.
Price to Earnings Formula
Price to Earnings = Current Market Price/Earnings per share
The easiest way to use a PE ratio is to compare it to a benchmark, such as another company in the same industry, the entire market, the industry average, or the same company at a different point in time.
A company that’s trading at a lower P/E than its industry peers could be a good value, but remember that even firms in the same industry can have very different capital structures, risk levels, and growth rates, all of which affect the price to earnings ratio.
All else equal, it makes sense to pay a higher P/E for a firm that’s growing faster, has less debt, and has lower capital re-investment needs.
Quick Ratio formula
Quick Ratio = (Current assets - Inventories)/Liabilities
In the event that short-term obligations need to be paid off immediately, there are situations in which the current ratio would overestimate a company's short-term financial strength.
By taking inventories out of the equation, Quick Ratio lets us find out if a company has sufficient liquid assets to meet its short-term operating needs.
It is especially useful for manufacturing firms and for retailers because both of these types of firms tend to have a lot of their cash tied up in inventories.
Calculating Quick Ratio
Quick Ratio is simply calculated by subtracting Inventories from Current Assets and dividing the result by Current Liabilities.
Inventories, Current Assets and Current Liabilities can be found in the Balance Sheet filed in the firm's Annual Reports.
Current Assets are those likely to be used up or converted into cash within one business cycle, usually defined as one year. Liabilities, similarly are those that have to be paid within a period of one year.
There are several types of inventories, including raw materials that have not yet been made into a finished product, partially finished products, spare parts, and finished products that have not yet been sold.
Rough benchmarks for analyzing a stock's Quick Ratio
In general, a quick ratio higher than 1.0 puts a company in fine shape but always looks to other firms in the same industry to be sure.
Price- Earnings (PE) Ratio
It is the most popular valuation measure, the Price to Earnings ratio or the PE ratio.
The nice thing about P/E is that accounting earnings are a much better proxy for cash flow than sales, and they are more up-to-date than book value.
Moreover, earnings per share results (and estimates) are easily available from just about any financial data source imaginable, so it’s an easy ratio to calculate.
Price to Earnings Formula
Price to Earnings = Current Market Price/Earnings per share
The easiest way to use a PE ratio is to compare it to a benchmark, such as another company in the same industry, the entire market, the industry average, or the same company at a different point in time.
A company that’s trading at a lower P/E than its industry peers could be a good value, but remember that even firms in the same industry can have very different capital structures, risk levels, and growth rates, all of which affect the price to earnings ratio.
All else equal, it makes sense to pay a higher P/E for a firm that’s growing faster, has less debt, and has lower capital re-investment needs.
Practical Implications:
You can also compare a stock's P/E to the average P/E of the entire market.
However, the same limitations of industry comparisons apply to this process as well.
The stock you are investigating might be growing faster (or slower) than the average stock, or it might be riskier (or less risky).
In general, comparing a company’s P/E with industry peers or with the market has some value, but these don’t approach that you should rely on to make a final buy or sell decision.
Comparing a stock’s current P/E with its historical Price to earnings ratios can be useful, especially for stable firms that haven’t undergone major shifts in their business.
If you see a solid company that’s growing at roughly the same rate with roughly the same business prospects as in the past, but it’s trading at a lower P/E than its long-term average, you should start getting interested.
It’s entirely possible that the company’s risk level or business outlook has changed, in which case a lower P/E is warranted, but it’s also possible that the market is simply pricing the shares at an irrationally low level.
This method works generally with more stable, established firms than with young companies with more uncertain business prospects.
Firms that are growing rapidly are changing a great deal from year to year, which means their current P/Es are less comparable to their historical P/Es.
P/E drawbacks
A PE ratio of 12, for example, is neither good nor bad in a vacuum.
Using PE ratios only on a relative basis means that your analysis can be skewed by the benchmark you are using. (Peer, industry, market).
So, let’s try to look at the PE ratio on an absolute level.
What factors would cause a firm to deserve a higher PE ratio?
Because risk, growth, and capital needs are all fundamental determinants of a stock’s PE ratio
Higher growth firms should have higher PE ratios
Higher risk firms should have lower P/E
Firms with higher capital needs should have lower P/E.
Firms that have to shovel in large amounts of capital to generate their earnings run the risk of needing to tap additional funding, either through debt (which increases the risk level of the company) or through additional equity offerings (which may dilute the value of current shareholders’ stake).
Either way, it is rational to pay less for firms with high reinvestment needs because each dollar of earnings requires more of shareholders’ capital to produce it.
A firm that’s expected to grow quickly will likely have a larger stream of future cash flows than one that’s growing slowly, so all else equal, it’s rational to pay more for the shares (thus the higher price to earnings ratio).
If a firm is riskier –maybe it has high debt, maybe it’s highly cyclical, or maybe it’s still developing its first product –has a good chance of having lower future cash flows than we originally expected, so it’s rational to pay less for the stock.
The abundance of free cash flow is likely to have low reinvestment needs, which means that a reasonable PE ratio will be somewhat higher than for a run-of-the-mill company.
Firms with higher growth rates, as long as that growth isn’t being generated using too much risk.
Some other aspects that can distort PE ratios
Keep these questions in the back of your mind when looking at P/E, and you’ll be less likely to misuse them.
Has the firm sold a Business or an Asset recently?
If a firm has recently sold off a business or perhaps a stake in another firm, it’s going to have artificially inflated earnings, and thus a lower P/E.
Because you don’t want to value the firm based on one-time gains such as this, you need to strip out the proceeds from the sale before calculating the P/E.
Has the firm taken a big charge recently?
If a firm is restructuring or closing down plants, earnings could be artificially depressed, which would push the P/E up.
For valuation purposes, it is useful to add back the charge to get a sense of the firm’s normalized P/E.
Is the firm cyclical?
Firms that go through boom and bust cycles –commodity companies, auto manufacturers are good examples –require a bit more care.
Although you will typically think of a firm with a very low trailing P/E as cheap, this is precisely the wrong time to buy a cyclical firm because it means earnings have been very high in the recent past, which in turn means they are likely to fall off soon.
Does the firm capitalize or Expense its Cash flow generating assets?
A firm that makes money by inventing new products –drug firms are the classic example- has to expense all of its spendings on research and development every year.
Arguably, it’s that spending on R&D that’s really creating value for shareholders.
Therefore, the firm that expenses assets will have lower earnings –and thus a higher P/E- in any given year than a firm that capitalizes assets.
On the other hand, a firm that makes money by building factories and making products gets to spread the expense over many years by depreciating them bit by bit.
Price to Sales ratio
The most basic ratio of all is the Price to Sales ratio, which is the current price of the stock divided by sales per share.
The nice thing about the P/S ratio is that sales are typically cleaner than reported earnings because companies that use accounting tricks usually seek to boost earnings.
In addition, sales are not as volatile as earnings –one-time charges can depress earnings temporarily, and the bottom line of economically cyclical companies can vary significantly from year to year.
Price to Sales Formula
Price to Sales = Current stock price /Sales per share
This relative smoothness of sales makes the P/S ratio useful for quickly valuing companies with highly variable earnings, by comparing the current P/S ratio with historical P/S ratios.
However, the P/S ratio has one big flaw. Sales may be worth a little or a lot, depending on a company’s profitability.
If a company is posting billions, but it is losing money on every transaction, we would have a hard time pinning an appropriate P/S ratio, because we have no idea what level (if any) profits the company will generate.
Therefore, although the P/S ratio might be useful if you are looking at a firm with highly variable earnings –because you can compare today’s P/S with a historical P/S ratio – it’s not something you want to rely on very much.
In particular don’t compare companies in different industries on a price-to-sales basis, unless the two industries have very similar levels of profitability.
Price to Book ratio
Another common valuation measure is a price to book ratio (P/B), which compares a stock’s market value with the book value (also known as shareholder’s equity or net worth) on the company’s most recent balance sheet.
The idea here is that future earnings or cash flows are ephemeral, and all we can really count on is the net value of a firm’s tangible assets in the here-and-now.
Legendary value investor Benjamin Graham, one of Warren Buffet’s mentors, was a big advocate of book value and P/B in valuing stocks.
Price to Book Formula
Price to Book = Current Market Price/Book Value per share
Although the price to book ratio still has some utility today, the world has changed since Ben Graham’s day.
When the market was dominated by capital-intensive firms that owned factories, land, rail track, and inventory –all of which had some objective tangible worth – it made sense to value firms based on their accounting book value.
But now many companies are creating wealth through intangible assets such as processes, brand names, and databases most of which are not directly included in book value.
For service firms in particular Price to book ratio has little meaning.
If you used P/B to value eBay, for example, you wouldn’t be according to a shred of worth to the firm’s dominant market position, which is the single biggest factor that has made the firm so successful.
Price-to-book may also lead you astray for a manufacturing firm such as 3M, which derives much of its value-form its brand name and innovative products, not from the size of its factories or the quantity of its inventory.
Another item to be wary of when using P/B to value stocks is goodwill, which can inflate book value to the point that even the most expensive firm looks like a value.
When one company buys another, the difference between the target firm’s tangible book value and the purchase price is called goodwill.
It’s supposed to represent the value of all the intangible assets –smart employees, strong customer relationships, and efficient internal processes –that made the target firm worth buying.
Be highly skeptical of firms for which goodwill makes up a sizeable portion of their book value.
Price to Book & Return on Equity
The price to book ratio is also tied to Return on Equity (equal to net income divided by book value) in the same way that price-to-sales is tied to net margin (equal to net income divided by sales).
Given two companies that are otherwise equal, the one with a higher ROE will have a higher P/B ratio.
The reason is clear – the firm that can compound book equity at a much higher rate is worth far more because book value will increase more quickly.
Therefore when you are looking at P/B, make sure you relate it to ROE.
A firm with low P/B relative to its peers or to the market and a high ROE might be a potential bargain, but you will want to do some digging before making that assessment based solely on the P/B.
Price to Book - valuing Financial Services firms
Although P/B isn’t very useful for service firms, it’s very good for valuing financial services firms because most financial firms have considerable liquid assets on their balance sheets.
The nice thing about financial firms is that many of the assets included in their book value are marked-to-market –in other words, they are revalued every quarter to reflect shifts in the marketplace, which means that book value is reasonably current.
A factory or a piece of land, by contrast, is recorded on the balance sheet at whatever value the firm paid for it, which is often very different from the asset’s current value.
As long as you make sure that the firm does not have a large number of bad loans on its books, P/B can be a solid way to screen for undervalued financial firms.
Dividend Yield
A popular yield-based measure used to value stocks is the dividend yield.
It allows investors to compare the latest dividend they received with the current market value of the share as an indicator of the return they are earning on their shares.
Note, though, that the current market share price may bear little resemblance to the price that an investor paid for their shares.
Dividend Yield Formula
Dividend Yield = Latest Annual Dividends per share/current market price per share
Dividend Yield is thus an easy way to compare the relative attractiveness of various dividend-paying stocks.
It tells an investor the return he/she can expect by purchasing a stock and can thus be compared with other investments such as bonds, certificates of deposit, etc.
Investors who look to secure some regular income from their investments can do so by investing in stocks paying relatively high, stable dividend yields.
For example, if two companies both pay annual dividends of Rs.10 per share, but company A's stock is trading at Rs.200 while company B's stock is trading at Rs.400, then company A has a dividend yield of 5% while company B is only providing a yield of 2.5%.
In this case, if we assume all other factors are equivalent, investors looking to supplement their income would likely prefer company A's stock over that of company B.
In Reference to companies.
Mature, well-established companies tend to have higher dividend yields, while young, growth-oriented companies tend to have a lower yield.
Many fast-growing companies do not have a dividend yield at all because they do not pay out dividends as they reinvest all the cash in expanding the business.
What to look for while analyzing a stock's dividend yield?
A high dividend yield may be an indication of a stock's current attractiveness. However, this can be misleading, if not sustained.
Look at the dividend-paying history of the company of the last 5 years.
A track record of maintaining and/or increasing dividends per share over the years is one indication of the sustainability of dividends.
A consistent dividend payout ratio for a firm with stable growth offers better clues towards the sustainability of dividends.
Earnings Yield
The first yield-based measure is what is called the Earnings Yield.
In addition to multiple-based measures, you can also use yield-based measures to value stocks.
If we invert the P/E and divide a firm’s earnings per share by its market price, we get an earnings-yield.
If a stock sells for Rs. 200 per share and has Rs.10 in earnings, it has a P/E of 20 (20/1) but an earnings-yield of 5% (1/20).
Earnings Yield Formula
Earnings Yield = Earnings per share / current market price
The nice thing about yields, as opposed to P/Es, is that we can compare them with alternative investments such as fixed deposits, to see what kind of a return we can expect from each investment.
The difference is that earnings generally grow over time, whereas fixed deposit payments are fixed.
A stock with a P/E of 20 would have a yield of 5 percent which is worse than the current bank FD rate of 8%. A stock with a P/E of 10, however, will have a yield of 10% which is better than the FD rates.
Thus I might be induced to take the additional risk.
Cash Return ratio
The best yield-based valuation measure is a relatively little-known metric called the Cash Return ratio.
In many ways, it’s actually a more useful tool than the P/E.
To calculate cash return, divide free cash flow by enterprise value.
Cash Return Formula
Cash Return = Free Cash Flow/Enterprise Value = Free Cash Flow/(Market Cap + debt – Cash)
The goal of Cash Return is to measure how efficiently the business is using its capital –both equity and debt-to generate free cash flow.
Essentially cash return tells you how much free cash flow a company generates as a percentage of how much it would cost to buy the whole shebang, including the debt burden.
Cash Return is a great first step to finding cash cows trading at reasonable prices.
Conclusion
The above mentioned is an extensive detailed summary of all the important ratios that one needs to know for basic analysis in their research. Hope you had great insight and it will surely expand your understanding horizon for ratio.
Financial ratio analysis is aimed to assess the financial performance and determine the financial position of an organization through its profitability, liquidity, activity, leverage, and other relevant indicators. There are many groups and individuals with diverse and conflicting interests but want to know about the business performance or position. In the following table major users of financial statements with their areas of interest.
Disclaimer: The information provided on Shuchi Nahar’s Weekend Blog is for educational purposes only. The articles may contain external links , references and compilation of various publicly available articles. Hence all the authors are given due credit for the same. All copyrights and trademarks of images belong to their respective owners and are used for Fair Educational Purpose only.
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