Hello Readers

Picking good stocks has always been a very
difficult task; however this can be made simpler to some extent with the help
of some financial ratios which are the reflection of the financial &
operational strength of the company. Here are 12 financial ratios
upon which every Investor should analyze companies before making any Investment
decision.

**To begin with popular one, P.E is an indication of “how many times of EPS is the price of share quoted”. In simpler words, it indicates how much Investors are ready to pay for each rupee of earnings.**

__Price-Earning (P.E.) Ratio:__
A high P.E ratio indicates that the stock is overpriced.
It depicts that investors are ready to pay excessive for its each rupee of
earning the reason being future prospects, growth or any positive developments.
Often these expectations are more intense which are unlikely to be met by companies. What do you expect when the markets realize this ??

To be on safer side one should go
for low P.E companies. Low P.E may be different for different industries, for
eg. A P.E of 20 may be expensive for any textile company whereas the same is cheap for any I.T company. P.E ratio shall therefore provide a better picture
if compared with industry P.E. Also, it should be used with other financial
ratios for better decision making.

__FORMULA: P.E. RATIO = PRICE / EPS__

**One Major drawback of using P.E ratio is that it is only based on current earnings and do not take into account the growth potential of the company. To rescue the same, one should also use PEG ratio along with P.E ratio.**

__PEG (P.E to growth) Ratio :__
It is computed as,

__PEG Ratio = P.E ratio / EPS growth__
Lower the PEG ratio, the better stock is
valued. Usually PEG<1, is considered as an attractive investment
opportunity.

Illustration:

Let’s assume there are two companies with
following features:

Company A: P.E Ratio = 20, Anticipated EPS
growth = 12%

Company B : P.E. Ratio = 30, Anticipated
EPS growth = 40%

Anyone looking just at P.E ratio may
conclude that company A is a value BUY, but high earnings growth rate of B is
being completely ignored. Now let’s use PEG ratio to amend the shortcoming

PEG ratio of A : 20/12 = 1.66

PEG ratio of B: 30/40 = 0.75

Although Company B has a higher P.E but the
same is compensated by higher anticipated growth..i..e.. the earnings of the
company are expected to increase at a greater pace resulting in higher EPS. If
there is higher EPS, P.E ratio will be justified in future (think of impact on
P.E. ratio in future) whereas in case of Company A its lower growth will not be
able to justify a P.E. of 20.

You might be wondering how to compute
growth rate??

Use EPS of previous 5 years and compute
compounded annual growth rate (CAGR), but this is past growth rate and future
is uncertain, therefore calculate range of values for a better picture. Like
what will be the PEG ratio “if same growth rate prevails”, “if growth rate increases
by 10%”, “if Growth rate reduces by 20%”.

DRAWBACKS: PEG ratio shouldn’t be used for
cyclical companies. Like in case of sugar industry, sugar companies have
reported a spectacular growth rate in EPS for past 2 years but the same cannot
be expected to continue in future. Therefore we cannot anticipate approximate growth
rate here. Hence, using past year EPS figures will always provide irrelevant
results. Anticipating growth rate is always a difficult task and one cannot get
it right every time.

__M__**Also Known as price to sales ratio, it indicates how the market is valuing every rupee of company’s sales. It can also be used as an alternative for P.E for the loss making cyclical companies. Low debt with market cap to sales below 1 is considered attractive investment opportunity in case of such companies.**

__arket Cap to Sales ratio:__
Market Cap = Total no. of share issued X
Market Price

__Market Cap to Sales ratio : Market Cap / Sales__

**The reason I prefer Gross Profit Margin Ratio over Operating profit Margin (OPM) & Net profit margin (NPM) is its reliability, OPM & NPM are comparatively easy to manipulate. It tells us how good a company is in manufacturing its products when compared to peers. More efficient companies see higher GP margins; it reflects that they have been able to figure out a way to reduce its cost of goods sold.**

__Gross Profit Ratio:__

__FORMULA: GROSS PROFIT/ SALES__
Gross Profit = Sales – Cost of Goods sold

Cost of Goods sold = Opening Stock +
Purchases + Direct Expenses – Closing Stock

__Return on Equity (ROE):__ROE reflects the company’s ability to generate profits from the moneys which shareholders have invested in it. As a rule of thumb, “companies with ROE of 20% and above are considered good investments”. It is computed as under :

__FORMULA = Net Profit / Shareholder’s Equity__

Shareholder’s equity can be computed either as
Total Assets – All liabilities or can be computed as Equity share capital +
Reserves & Surplus

**ROE may not be suitable for companies with heavy debts, as the moneys flow not only by means of equity but also from financial institutions in form of debt, therefore it makes sense only when return on entire capital employed is computed instead of equity.**

__Return on Capital Employed (ROCE):__

__FORMULA = Earnings Before Interest & Tax(EBIT)/Capital Employed__

Capital Employed = Shareholder’s Equity (as
computed in 5) + Long Term Debts

**It indicates the extent to which shareholder’s equity can meet its current & non-current liabilities in case of liquidation. Generally a debt equity ratio below 1 is considered better, however this depends upon industry to industry, like a capital intensive company may have DE above 2 whereas the same may be lower for any service sector company, therefore it is always better to compare DE of a company with its peers.**

__Debt-Equity Ratio:__
High
debts not only make it difficult to raise further funds to meet business
requirements but also affect the Net profit Margin & EPS severely.
Moreover, companies with higher debts will find it difficult to survive in
recessions due to higher interest expense burden.

__FORMULA = Total Debt/Equity (shareholders funds)__

**It reflects the company’s ability to pay off interest on its outstanding debt. In other words, it indicates whether the business has earned sufficient profits to pay periodically the interest charges.**

__Interest Coverage ratio:__

__FORMULA = EBIT/Interest Expenses__
The interest coverage ratio is a measure of
the number of times a company could make the interest payments on its debt with
its EBIT. The result should be compared with that of peers to arrive at better
conclusion.

**The asset turnover ratio is an efficiency ratio that measures a company's ability to generate sales from its assets by comparing net sales with average total assets. In other words, this ratio shows how efficiently a company can use its assets to generate sales. Higher turnover ratios mean the company is using its assets more efficiently**

__Asset Turnover ratio:__
Like with most ratios, the asset turnover
ratio is based on industry standards. Some industries use assets more
efficiently than others. To get a true sense of how well a company's assets are
being used, it must be compared to other companies in its industry.

__FORMULA = NET SALES/TOTAL ASSETS__**Inventory turnover is an efficiency ratio which calculates the number of times per year a business sells and replaces its entire batch of inventories. Inventory turnover is a very industry-specific ratio. Businesses which trade perishable goods have very higher turnover compared to those dealing in durables. Hence a comparison would only be fair if made between businesses in the same industry.**

__Inventory Turnover Ratio:__
For Example: If both company A & B
operating in same industry has Rs 20 00,000 of average inventory and A can sell
it all 10 times whereas B can sell it 5 times in a year, A shall be considered
more efficient and will incur lower stock holding & obsolesce losses.

__FORMULA = COST OF GOODS SOLD/AVERAGE INVENTORY__
COGS = as calculated in 4

Average Inventory = (opening inventory + closing
inventory) / 2

Inventory turnover ratio can also be calculated
in days, like in above example company A clears its inventory in 365/10 = 36.5
days whereas B clear it in 365/5 = 73 days.

**This ratio gives the analysts and investors indications about the ability of a company to generate cash from its sales. In other words, it shows the ability of a company to turn its sales into cash. It is expressed as a percentage. Ideally there should be a parallel increase in operating cash flows with the increase in sales. It will be worrisome if the changes in cash flows are not parallel to the changes in sales revenue.**

__Operating Cash Flow to Sales Ratio:__
It is a known fact that companies can
fudge the sales number relatively easily. This can be done by changing the
revenue recognition policy which allows accountants to book future income as
income today. Sometimes companies do fake transactions to ensure that sales
numbers look good to the stock market. However, the acid test comes when sales
need to be converted to cash. Only genuine sales bring in cash flow.

__FORMULA = OPERATING CASH FLOW / SALES * 100__
Operating cash flow figures can be obtained
from Cash Flow Statement under heading “Cash Flow from Operating Activities”

If this ratio comes out to be 60%, it is read
as “the company has been able to realize 60% of sales into cash, which it can
use to pay its employees, suppliers, invest in equipment and distribute to shareholders
as dividends”.

**Free Cash flow is the cash left with the company after meeting its capital expenditures, Free cash flow = operating cash flow – capital exp.**

__Free Cash Flow to Operating Cash Flow ratio :__
Therefore this ratio indicates percentage
of cash flow left free out of operating cash flow generated by the company.

This “Free” cash flow can be used by the
company for expansion, acquisitions and coping up with difficult situations.
Thus a higher ratio reflects financial strength of the company.

__FORMULA = FCF TO OCF RATIO = FCF/OCF__

These 12 ratios can be great if used while picking stocks as
they try to cover every aspect of the company. Investors can add on other
ratios too as per their intellect. The motive is to identify best investment opportunities
and exploit them to the fullest. Happy Investing !!!

Thank you !!!

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## 2 comments

Master Article.....very informative !!!

excellent articles

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