Ratio Analysis for Stock Trading

Overview

When an individual buys shares in a company, his primary goal is to put his hard-earned money into the stocks of company in a stable enterprise that would likely enable him to build up wealth over time. However, to ensure that the money is invested in a financially solid and successful business, stock market research of financial data through a company’s financial statements (i.e., profit and loss statement, balance sheet, cash flow statements), etc. is required, which requires an immense amount of time and effort.

But ratio analysis is an effective method of doing a financial analysis of stock through careful study of financial ratios. These financial parameters are available to make the life of a stock investor relatively uncomplicated. Using these statistics, stock market investors can analyse both businesses’ financials to determine which one presents the greater investment opportunity. In this article, we will explore ratio analysis, its applications, advantages and disadvantages in this post and the key financial ratio analyses that every stock investor should be aware of.

Ratio Analysis- Meaning and Purpose

Ratio analysis is the cornerstone of fundamental analysis, used to assess and portray the financial stability of an organisation and its cash flows. A company’s financial statements are carefully prepared to accurately reflect the health of its operations.

Therefore, Ratio analysis is a quantitative strategy used to help stakeholders understand the organisation’s financial state. Since it offers an unbiased and independent perspective of the company’s health, investors and analysts use it to learn about its liquidity, operational effectiveness, and profitability before investing. Furthermore, it is useful to determine financial performance by calculating profitability, liquidity, activity, debt, and market ratios. The ratios for inventory turnover, gross profit margin, and current ratio are a few instances of ratio analysis.

Key Features of Ratio Analysis

• Ratio analysis gives information on how a business has performed over the years compared to other businesses in the same sector.
• Ratio analysis examines line-item information from a company’s financial records to unearth insights on profitability, liquidity, operational effectiveness, and solvency.

Importance of Ratio Analysis

Before investing, wise investors assess a company’s financial performance using financial ratios. Financial ratios show a company’s financing structure, resource allocation, debt-paying capacity, and profit-making potential. Ratios give a perspective of a company’s situation at a given time. They are most helpful when compared across periods and between businesses in the same industry. Although ratios do not provide a complete picture of a company’s investment potential, they are a good beginning to start the research.

The importance of ratio analysis lies in its potential to present a more accurate picture of a company’s operating health. Consider a company with Rs 1 Crore in revenue in the previous quarter. Although everything appears in order, the company may have seen lower earnings relative to equity than in prior periods, a fall in liquidity ratio indicators, and a negative gross profit margin. It’s possible that static statistics alone cannot fully explain a company’s performance. As an illustration, consider the inventory turnover ratio, which measures how quickly a company turns over its products for sale. A company can monitor its inventory turnover over a year to better understand how quickly products are converted into cash each month. The company can then look into the reasons for the underperformance of the business or the period when the company performed better than expected. External parties who set benchmarks frequently linked to risk may also demand ratio analysis. Even while ratios can be a useful tool for understanding a business, they should be used in conjunction with other indicators to provide a more comprehensive view of a company’s financial health.

Categories of Ratio Analysis

Several financial ratios are used for ratio analysis, and they are divided into the following categories-

• Liquidity ratios- Liquidity ratios gauge a company’s capacity to service its debt against the current assets of the company. If a business faces difficulties in making its end meet or cannot pay off its debts, it can sell its assets to raise cash, which it can use to easily pay off any outstanding obligations. Quick, cash, and current ratios are a few examples of frequent liquidity ratios. Banks, creditors, and vendors use liquidity measures to assess clients’ capacity to meet future financial obligations.
• Solvency Ratios- The long-term financial viability of a company is measured by its solvency ratios. These ratios assess how much debt a business has concerning its assets, equity, or annual profits. The debt-to-capital ratio, debt ratio, interest coverage ratio, and equity multiplier are crucial solvency ratios. Governments, banks, workers, and institutional investors use solvency ratios most frequently.
• Profitability Ratios- Profitability ratios assess an organisation’s potential to make money in relation to the costs that go along with it. The profitability ratio is higher than during the preceding financial reporting period, indicating that the company’s financial situation is improving. To ascertain how profitable a company is compared to its rivals, one may also compare a profitability ratio to the ratio of a similar organisation. Relevant profitability ratios include, for instance, the return on equity ratio, return on assets, profit margin, gross margin, and return on capital employed.
• Efficiency ratios- Efficiency ratios assess the efficiency with which the company uses its assets and liabilities to produce sales and make a profit. In addition to calculating the use of equity, they also compute the use of inventory, machinery, and liabilities. These ratios are crucial because rising efficiency ratios increase a company’s potential for increased sales and profit. The asset turnover ratio, inventory turnover, payables turnover, working capital turnover, fixed asset turnover, and receivables turnover ratio are only crucial efficiency ratios.
• Coverage ratios- Coverage ratios evaluate a company’s capacity to pay debt and other obligations. Analysts can use the coverage ratios from various reporting periods to create a trend forecasting the company’s future financial status. The ability of a company to pay off its debts and related responsibilities is increased by a higher coverage ratio. The debt coverage ratio, interest coverage, fixed charge coverage, and EBIDTA coverage are crucial.
• Market prospect ratios- Market prospect ratios assist investors in forecasting their potential returns on particular investments. Future dividends or a rise in the shares’ value are two ways earnings may be expressed. Investors can utilise current earnings and dividends to help predict the likely stock price and the dividends they anticipate receiving. Dividend yield, earnings per share, price-to-earnings ratio, and dividend payout ratio are important market prospect measures.

What are the benefits of Ratio Analysis?

• Trend Identification- Ratio analysis allows businesses to recognise a pattern in their performance, which is one of its main benefits. Analysts gather and contrast financial information from various accounting years when doing ratio analysis. This detailed analysis and comprehension of the financial accounts aid in identifying a trend that will further offer insights into its future performance.
• Facilitates comparison between businesses- The ability to compare the financial performance of two or more organisations is another significant advantage of this quantitative research. Since these ratios are numerical indicators, it is simple to determine a company’s performance by examining the value in question.
• Performance effectiveness- It aids businesses in making critical operational decisions. As a result, businesses can decide whether to move forward with or postpone a certain managerial choice based on examining the relevant ratios. Ratio analysis is straightforward, making it simple to comprehend. Therefore, it facilitates management’s ability to make decisions quickly.
• Indication of business liquidity- Ratio analysis aids in determining a company’s ability to pay short-term debt or its liquidity situation. Banks, creditors, and other short-term loan providers use liquidity measures to help them evaluate a company’s ability to pay its debts.
• Provide caution in cases of red flags-When a corporation experiences a serious liquidity issue and persistent loss-making, it is considered sick. To take prompt action to stop such sickness, proper ratio analysis can provide early warning signs of corporate sickness to enable investors to take prompt decisions to save themselves from risks.

Are there any limitations of financial ratios?

The information utilised in the study depends on past results that the company releases, which is one of the ratio analysis’s most significant drawbacks. As a result, measurements from ratio analysis may not accurately predict future business performance.

• Effects of inflation- Because financial statements are periodically generated, each publication has time gaps. Real prices do not appear in the financial accounts if inflation occurs between periods. As a result, unless the figures have been adjusted for inflation, the data from various periods cannot be compared.
• Historical Data- The data utilised in the study is based on actual past performance disclosed by the company. As a result, measurements from ratio analysis may not accurately predict future business performance.
• Accounting policy modifications- The financial reporting may be considerably impacted if the organisation has altered its accounting principles and procedures. The essential financial measurements utilised in this case for ratio analysis are changed, and the financial outcomes recorded after the change are not comparable to those recorded before the change. The analyst must keep abreast of modifications to accounting principles. Changes are usually noted in the notes to the financial statements section.
• Operational adjustments- A business may change its operational structure significantly, including its supply chain strategy or the products it sells. The comparison of financial measures before and after large operational changes may result in misleading assessments of the company’s performance and prospects.
• Seasonal effects- An analyst should be aware of seasonal variables that may limit the use of ratio analysis. If the ratio analysis is not corrected for the impacts of seasonality, the analysis results may be interpreted incorrectly.
• Financial information is prone to manipulation- Ratio analysis is based on information the company reports in its financial statements. However, such information could be manipulated by the business management to report better results than the company’s true performance. As a result, ratio analysis may not adequately reflect the firm’s underlying nature since the simple analysis cannot identify informational distortion. Therefore, it is crucial that an analyst is aware of such potential manipulations and always does thorough due diligence before drawing any conclusions.

Key Financial ratio every investor should know

Financial ratios simplify the analysis of financial statements such as the balance sheet, profit and loss accounts, and cash-flow statements. Financial ratios provide efficiency to investors by helping them quickly understand financial statements.

Using these tools, stock market investors may choose the best enterprises to invest in or evaluate the financials of the business to determine which one has a higher investment potential-

• Earnings Per Share (EPS): Earnings per share (EPS) is the essential measure of the financial soundness of the business. It is arrived at by dividing the business’s net income by the total number of outstanding shares. EPS is the portion of a company’s profit allocated to every individual share of the stock and holds value for traders and investors. Typically, EPS could be applied as a tool by market participants to measure the profitability of a business before making any purchasing decision, as a higher EPS ratio means higher business profitability and vice-versa. The profitability of an organisation can usually be determined by its earnings per share ratio and vice versa.

Earnings Per Share (EPS) = Net income – Dividends from preference shares

• Average outstanding shares- It is computed on a quarterly or annual basis and doesn’t consider the earnings from preference shares of a business. From the investor’s perspective, investing in a business with a higher and growing EPS ratio is always recommended. Therefore, before deciding to invest in any business, investors should check the company’s EPS ratios for the past five years. If the EPS has been growing steadily these years, it could be a good sign and a green signal to go ahead. But, if the EPS regularly falls, the investor should try looking for another company.
• Price-to-Earnings Ratio- The price-to-earnings, or P/E, is a ratio employed by the investors to determine the growth potential of a given stock and signals the willingness of the investors to pay for each rupee of earnings of the business, reflecting whether the market is either undervaluing or overvaluing the business. Therefore, the P/E ratio is often used to compare the potential value of a certain stock/s. The P/E ratio could be calculated by-

Price Earnings Ratio= Current Stock Price

                                         Earnings Per Share

Where an investor wishes to identify the ideal PE ratio, he must consider the company’s average past PE ratio, the industry average, and the market P/E of the stock. For instance, the stock of XYZ at 19 may look overvalued, but if the average industry is 21 with the market at 23, it might still be a sound investment. Stocks with a higher PE ratio may suggest that it is overvalued, whereas stocks holding a lower PE ratio may prove that the business is yet to realise its full potential. Although the PE ratio as a financial metric offers insights into a stock’s profitability, it should be employed in tandem with other financial ratios to make a well-informed decision.

• Return On Equity (ROE)- The net income distributed as a percentage of shareholders’ equity is known as return on equity (ROE). ROE assesses a company’s profitability by disclosing how much profit it earns with the money invested by shareholders. In other words, ROE reflects how effectively a business compensates its shareholders for their investment. The formula for ROE shall be-

Return on Equity = (Net Income)

                       (Average Stockholder Equity)

Hence, investing in a business with an ROE above 20% for at least the last 3 years is generally recommended. Further, a business witnessing year-to-year (YoY) growth in ROE could also be good.

• Price to Sales Ratio- The price-to-sales ratio considers the stock’s market capitalisation (the number of shares outstanding multiplied by the share price) as well as the company’s revenue to assess whether the stock is sufficiently valued. To calculate the price-to-sales ratio, divide the share’s current market price by the company’s 12-month average revenue per share or annual sales. The formula for calculation of the price-to-sales ratio shall be-

Price to Sales Ratio = Price per Share

                                    Annual Sales Per Share

Stocks with lower P/S ratios are considered more effective investments and vice-versa. Price-to-sales provides a useful measure for sizing up stocks, as it represents how much the market values for every rupee of the sales generated. Thus, the P/S ratio could be an effective tool in valuing those growth stocks that are yet to realise their potential or have unfortunately witnessed a temporary setback. For the investors, the ratio could be used for identifying recovery situations or assuring themselves that the growth of the business isn’t unnecessarily inflated.

• Current Ratio- The current ratio is an important financial indicator for determining a company’s liquidity. It determines how much a current asset’s value can be used to pay current liabilities. You can compute the current ratio as follows:

Current Ratio = Current Assets

                           Current Liabilities

The current ratio is an effective tool helpful to ascertain the business’s solvency by gauging its capability to meet its short-term obligations. If the current ratio of a business is less than 1, it indicates that the business is riskier and incapable of meeting its short-term liabilities. Investing in the same would be a financially riskier choice and vice-versa. Thus, investing in a business with a current ratio higher than one is advisable.

• Price to Book Value- The price-to-book value (P/BV) ratio is a financial ratio that compares a business’s market price per share to its book value. In plain terms, book value means the sum remaining if the company undergoes liquidation and all debts are paid off to the creditors. The formula for determining Price to Book Value shall be-

Price to Book Ratio = Price per Share/Book Value per Share

The P/BV ratio determines the stock value in companies with significant balance sheet tangible assets. It provides insight into a company’s intrinsic worth, helps determine the value of businesses with predominantly liquid assets, and reflects the price shareholders would be willing to pay for their net assets.

• Debt to Equity (DE) Ratio- The debt-to-equity ratio contrasts a company’s debt with its capital (equity) from its promoters. It is computed by dividing a business’s total debt by the equity owned by shareholders. The formula for Debt-to-equity shall be as follows-

Debt to Equity Ratio = Total Liabilities

                                Total Shareholder Equity

Businesses with higher debt-to-equity ratios suggest that though the company may be leveraging its assets to finance growth, the business is rather unprofitable and surviving on borrowing rather than business revenue. Thus, it is recommended to avoid investing in stocks of a business with high Debt to equity ratio.

• Dividend Yield- The dividend yield is a measure of the profitability of a stock as an annual percentage. It could be determined by the division of the annual cash dividend paid by the company per share by the stock’s market value. The formula for computing dividend yield is as follows:

Dividend Yield = (Dividend per Share) X 100

                                         (Price per Share)

The dividend yield, for instance, will be 10% if a company’s share price is Rs. 100 and it pays a dividend of Rs 10. Many expanding businesses spend their earnings on furthering their expansion instead of paying dividends. Accordingly, investing in a business with a higher or lower dividend yield completely rests with the investor. Nevertheless, a stable or rising dividend yield is generally considered a positive indication for dividend investors.

• Price/Earnings to growth ratio (PEG)- PEG ratio or Price/Earnings to growth ratio is used to compute the value of a stock by considering the growth in a company’s business earnings. This ratio is considered more effective and useful than the PE ratio, as the latter fails to consider the company’s growth rate. The PEG ratio could be computed using this formula-

PEG ratio =       PE ratio

        Projected annual growth in earnings

A stock with a PEG ratio below one is typically considered to be a sound investment since it is discounted relative to its EPS growth rate, whereas a business with a ratio above one is considered to be overvalued.

• EV/EBITDA- The enterprise value to earnings before interest, taxes, depreciation, and amortisation ratio (EV/EBITDA) compares the worth of a firm, including debt, to the company’s cash earnings, less non-cash expenses.

As a turnover valuation ratio, it is a significant valuation tool to be employed by investors to assess companies with higher borrowing. The EV/EBITDA ratio could be determined by dividing a company’s enterprise value (EV) by its EBITDA.

Here,

EBITDA = Operating Income + Depreciation + Amortization

Enterprise Value = Market Capitalisation of the business +Debt -Cash

Stocks of a business with a lower EV/EBITDA value ratio indicate reasonable investment options.

• Return on capital employed (ROCE)- Return on Capital Employed is a profitability ratio that calculates the profits the business generates from the sum employed as capital. It represents how well the business has managed its business operations to generate higher revenues from business operations.

It could be calculated as-

ROCE=                  EBIT (Earnings before interest and tax)

                                               Capital Employed 

The total capital employed represents the capital employed by the business towards the growth of its business, which includes the shareholder’s equity and the business’s assets. Generally, investing in businesses with a higher ROCE than its rivals is regarded as a sound investment.

• Interest Coverage Ratio- The interest coverage ratio determines a company’s ability to pay its debt interest using its EBIT. For a business, having a larger interest coverage ratio is preferable because it illustrates the firm’s capacity to service its debt, its ability to make timely payments, and its creditworthiness for future borrowings. The interest coverage ratio can be computed using the following:

Interest coverage ratio = (EBIT/ Interest expense)

A corporation with an impressive and consistent interest coverage ratio is always a good investment. As a general guideline, stay away from investing in businesses with an interest coverage ratio of less than 1, as this could indicate problems and suggest the business lacks the resources to pay its interest.

Conclusion

The foundation of financial analysis that is utilised to gain a thorough understanding of a company’s performance is ratio analysis. It is a quantitative tool for comparing financial performance between years in relation to several significant factors. You can examine the past to make adjustments for the future, assess a company’s financial performance versus the sector average, and more. To provide a comprehensive picture, experts frequently combine various ratios. It will be easier for you to obtain a thorough understanding of a company from several perspectives and to confirm the validity of your investment decision if you have a solid understanding of ratio analysis.