Wednesday, June 29, 2022

Key Financial ratio

Financial ratios allow analysts and investors to convert raw data (from financial statements) into concise, actionable information. This information is used to

  • evaluate performance of the organization
  • compare companies and industries
  • conduct fundamental analysis

Some of the key financial ratios are.

  1. Return on assets (ROA) – it measures a company’s ability to generate income from its assets

Formula to calculate ROA – Net income/ Total assets *100

Ideal ROA ratio – ROA above 5% is considered good.

  • Return on Equity (ROE)- it measures a company’s ability to generate earnings in relation to its shareholders’ equity.

 Formula to calculate ROE – Net income/ Shareholder’s Equity *100

Ideal ROE ratio – ROA above 5% is considered good.

  • Current Ratio– Also called the working capital ratio, the current ratio measures a company’s ability to cover its current liabilities (debts due within one year) by using its current assets.

Formula to calculate Current ratio–   Current assets/ Current liabilities

 Ideal current ratio – Current ratio above 1% is considered good.

  • Acid test ratio/ Quick ratio: measures a company’s immediate ability to cover its current liabilities with its most liquid assets (e.g. cash, cash equivalents, marketable securities, accounts receivable). While similar to the current ratio, it excludes inventory and prepaid expenses since they can take weeks or months to turn into cash. 

Formula to calculate Quick /Acid test ratio- Liquid assets /Current liabilities

Ideal Quick /Acid test ratio -A value above 1 indicates that the company can immediately pay off its current liabilities using its liquid assets.

  • Debt Equity Ratio: It is a measure of a company’s debt in relation to its equity. It indicates the degree to which its operations are funded by debt and whether shareholders’ equity can cover total liabilities. 

Formula to calculate Debt Equity ratio- Total liabilities /Total Shareholder’s equity

Ideal Quick /Acid test ratio -Debit equity ratio below 1% is considered good.

  • Interest coverage ratio– Interest coverage ratio measures a company’s ability to pay the interest on its debt.

Formula to calculate interest coverage ratio– EBIT/ Interest expense

Ideal Interest coverage ratio– A value above 1 indicates that a company’s EBIT can cover its interest payments.

  • Debt service Coverage ratio ( DSCR): measures a company’s ability to cover its outstanding debt obligations (e.g. interest, principal, lease payments) using its operating income. This key financial ratio shows whether a company has enough income to cover its debts and is often used to evaluate a company’s credit risk and debt capacity.

Formula to calculate Debt Service coverage ratio: Net operating income /Total outstanding debts.

Ideal DSCR – A value above 1 indicates that the company has enough cash flow to cover its debt obligations.

  • Price to earning ratio ( PE ratio): it is the amount an investor must pay for each dollar of earnings. It indicates whether the market price of a stock reflects the company’s earnings potential or true value, and helps investors determine if it is under or overvalued.

Formula to calculate Price earnings ratio: Market price of the share/ Earning per share

Ideal PE ratio: Since this metric varies between industries, there is no benchmark for what makes a “good” P/E ratio. That said, a relatively high price-to-earnings ratio can indicate that the stock is overvalued or that it is expected to have significant future earnings growth. On the other hand, a low P/E ratio can indicate that either the stock is undervalued, or expectations are low.

  • Dividend Yield: it is an important financial ratio that measures of a company’s annual dividend payouts relative to its stock price.

Formula to calculate Dividend Yield ratio:  Dividend per share/Share price *100

  1. Asset Turnover ratio: The asset turnover ratio measures how efficiently a company generates sales from its assets.

Formula to calculate Asset turnover ratio : Net Sales / Average total assets

Ideal Assets turnover ratio:-  a number above one indicates that the company is efficient at using assets to generate sales (while a number below one indicates that it is not).

CA Divya Thakkar
Chartered accountant | IIM Bangalore 7+years of experience in Consultancy, Investment Banking, Ecommerce & IT Industry. Expert in IFRS, USGAAP, INDAS & US Regulatory requirement. Currently working with Deloitte Touche & Company in Risk ,Finance & Control advisory. Worked in Companies like Barclays Bank, HCL Technologies Ltd & BazaarCart.

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