Ratio analysis is vital for efficient investment decisions. Financial ratios are valuable tools that say a lot about a company’s health and its position in the market that help you make an informed investment choice. Ratios help you understand the profitability, valuation, solvency, and liquidity of the business that investors are investing in.
Price-to-earnings ratio is one of the most used valuation ratios that helps you compare the stock price to the company’s earnings on a per-share basis. It tells you how much the market is willing to pay INR 1 of the company’s future earnings. A Higher P/E ratio of a stock indicates that the company’s stock price is high compared to the value it brings in and vice versa. It is essential to know that companies in different industries have different P/E ratios. Price to earnings is calculated as below:
Price to earnings = Market value per share / Earnings per share (EPS)
The current ratio is a glimpse into the company's liquidity position or its ability to meet the short-term obligations with its current assets. The higher current ratio is considered favourable as it indicates the number of times the company's current assets can cover its short-term obligations. The current ratio is calculated as below:
Current ratio = Current assets/Current liabilities The current ratio between 1.5 to 3 is an indication of the company’s healthy financials. However, there is no upper cap on what is too much or very high. A higher current ratio would also mean that the company is keeping the excess cash idle instead of utilising it for growth.
The debt-equity ratio helps you understand how leveraged the business/company is. It compares a company’s debt to shareholder’s equity.
Debt to equity ratio = Total debt/ Shareholder’s equity A higher debt-equity ratio indicates that the company is leveraged and vice versa. That means a high debt-equity ratio shows the degree of risk associated with the business. However, the debt-to-equity ratio cannot be considered in isolation as it may vary depending on the industry and then cash flow generation in the business.
The dividend yield is the ratio that measures dividends paid out to shareholders by the company relative to the company’s stock price. The dividend yield is calculated as below:
Dividend yield = Annual dividend per share/Company’s stock price
If the company's dividend yield is high, that indicates the company is doing well and paying out a substantial share of its income in the form of dividends to its shareholders. However, the comparison of the company's dividend yield needs to be done based on the industry average. Ratio analysis gives a better idea of the stocks in the market by comparing the trends of two or more companies simultaneously. It helps analyse its efficiency, financial position, and operative efficiency, among others, to help you choose the best stocks for your investment portfolio and build significant wealth for your future.
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