For an average investor, analyzing financial statements could be a nightmare if one does not have basic accounting knowledge. So how can an average investor analyze financial statements of a company? This is where financial ratios come to the rescue. Financial ratios are data derived from the financial statements of a company (such as Balance Sheets, Profit and Loss Statement, and cash flow statements) and are presented as ratios, percentages and per share data. Financial ratios are easier to understand, simple to calculate and make comparisons of two companies easy.
Financial Ratios are divided in various categories such as profitability ratios, liquidity ratios, management efficiency ratios etc (To learn about types of financial ratios please read: Types of financial ratios and what they mean). Although there are many financial ratios in each category, being smart investors, you should use few, but most important financial ratios to analyze fundamentals of a company:
“Financial ratios can be an important tool for investors to measure progress of a company toward reaching their goals”
While analyzing a stock, first question you must ask is “How much does the company earn?” You can easily get that data in Company’s profit and loss statement. So why should you look at EPS and not Earnings? What Earnings data does not tell you is how much a company is earning on each share. EPS gives you the quality of earning by dividing company’s earnings on each share, a company with good earnings may be earning less on per share basis but a company with low earnings may be have high earning on per share basis.
Basic EPS is financial indicator which measures the total earning of a company on per share basis. In other words, Basic EPS measures how much the company earns on each share. It is calculated by dividing net income by total number of outstanding shares of the company. High EPS is an indication of healthy profits, a sign that company is doing well in its business. An investor should look for consistency and growth in EPS for at least 5-10 years, if the EPS growth is stagnant or is inconsistent, then you should be cautious.
EPS can also be used to compare two companies working in the same sector to find out which one is a better investment. A company with consistently rising EPS is a better investment.
“Although EPS is an important metric to measure profitability of a company, it should not be looked in isolation.”
Companies with huge debt on their books become risky investment even if they have high EPS. If company’s operating profits deteriorate in future, company still has to pay its debt. This will lead to lower operating profits, sometimes even losses. This is something you must be careful about as it affects the overall performance of a company and its future.
Net Profit Margins:
Net Profit Margin expresses how much profit company has earned out of total sales. Net Profit Margin is expressed in percent. Companies with high profit margins indicate that it is pricing its products correctly and has efficient cost control. Net Profit Margin can be used to compare two companies working in the same industry to find out which one is better investment. Net Profit Margin is calculated by dividing Net Profit by Net Sales multiplied by 100.
“Net Profit Margin should be above prevailing interest rates. Companies with low profit margins struggle to pay debt as interest expense hits their Net Profit Margins.“
Return On Capital Employed is a financial measure to show how well the company is using its capital to generates profits. ROCE is a better measurement than Return On Equity (ROE), because ROCE shows how well a company is using both its equity and debt to generate a return. Higher ROCE shows company is utilizing its asset and making higher profits on total capital employed.
Companies that need huge assets (such as companies involved in manufacturing e.g Iron and Steel business, automobile etc) to conduct their business usually have low ROCE as they have to charge higher depreciation on their assets and replace them frequently.
Companies with strong brand recognition and distribution channel combined with high barrier to entry and economic moat have better ROCE than their peers.
Debt to Equity:
Debt to Equity ratio tells us how a company is capitalized, that is how much of company’s total capital is financed by debt and how much is equity. A high debt to equity ratio means company is largely financed by debt such as corporate bonds and bank loans.
Companies with higher debt financing are considered to be a risky investment. Unlike equity, debt must be paid back to the lender with some interest. Debt financing also requires regular payment to the lender, which can be burdening for a company if it does not make enough profits.
What high Debt to Equity ratio also shows that investors have not funded the business probably because they feel company is not performing well. Due to this, companies have no other option but to raise funds using debt financing to run their business.
Dividend Payout Ratio and Dividend per Share:
Dividend is a part of company’s profit it distributes to its shareholders. A company making good profits distributes dividends regularly. Dividend payout ratio shows the portion of profit company decides to give away to its shareholders.
Dividend payout ratio is expressed in percentage of net profits. For example, if a company’s dividend payout ratio is 30%, it means that company has distributed 30% of its total net profit as dividends and rest 70% is kept by the company to fund its future operations.
Companies with strong dividend record are preferred by long term investors as it provides them a good source of income, especially when they retire and cannot continue to work.
Dividend Per Share is another financial ratio which tells us how much dividend a company is paying on each share. Investors are interested in Dividend per share ratio because it gives them a clear idea about how much dividend company has been paying in the past. A company with regular and rising dividend per share record is considered as good investment.
5 financial ratios mentioned above will give you the complete picture of a company’s business and financial performance. Using above mentioned financial ratios will not only save your valuable time you invest in analyzing a business, it will also make your analysis very crisp and uncomplicated. You should not look at any of these data in isolation, doing so will lead to faulty analysis and may cause serious damage to your financial health. All the ratios mentioned above should be put together in perspective and investment decision should be made on the basis of conclusions drawn.