Published on: September 19, 2024
Understanding financial ratios is crucial for making informed investment decisions. These ratios provide a snapshot of a company’s financial health, helping investors evaluate performance and compare it to peers. This article will walk through some essential financial ratios, explain their significance, and provide examples using Indian stocks.
1. Price to Earnings (P/E) Ratio
The P/E ratio measures a company’s current share price relative to its earnings per share (EPS). It tells investors how much they are paying for each rupee of earnings.
Formula: P/E Ratio = Market Price per Share/Earnings per Share (EPS)
Example:
Suppose Reliance Industries has a market price of ₹2,800 and an EPS of ₹100. The P/E ratio is: 2,800/100 = 28
This means that investors are willing to pay ₹28 for every rupee of earnings. A high P/E ratio may indicate that investors expect higher growth, while a lower P/E suggests the stock might be undervalued.
2. Price to Book (P/B) Ratio
The P/B ratio compares a company’s market value to its book value. It indicates whether the stock is over or undervalued.
Formula: P/B Ratio = Market Price per Share/Book Value per Share
Example:
State Bank of India (SBI) is trading at ₹900, and the book value per share is ₹300. The P/B ratio is: 900/300 = 3
This means SBI is trading at thrice its book value. A ratio below 1 may indicate that the stock is undervalued compared to its book value.
3. Debt to Equity (D/E) Ratio
The D/E ratio indicates a company’s financial leverage, comparing total liabilities to shareholder equity. A higher ratio suggests more debt, which can be risky during economic downturns.
Formula: D/E Ratio = Total Debt/Shareholders Equity
Example:
Consider Tata Motors, where total debt is ₹1,000 crore, and equity is ₹500 crore. The D/E ratio is: 1000/500 = 2
A D/E ratio of 2 means Tata Motors has ₹2 of debt for every ₹1 of equity, indicating significant leverage.
4. Return on Equity (ROE)
ROE measures a company’s profitability through shareholder’s equity. It shows how efficiently a company uses its equity base to generate profits.
Formula: ROE = Net Income/ Shareholders Equity
Example:
Assume HDFC Bank has a net income of ₹5,000 crore and shareholders equity of ₹25,000 crore. The ROE is:
ROE = 5000/25000 = 0.2 or 20%
This means HDFC Bank generates a 20% return on the equity invested by its shareholders.
5. Current Ratio
The current ratio measures a company’s ability to pay short-term liabilities with its short-term assets.
Formula: Current Ratio = Current Assets/Current Liabilities
Example:
Let’s say Infosys has current assets of ₹10,000 crore and current liabilities of ₹5,000 crore. The current ratio is:
Current Ratio = 10000/5000 = 2
A current ratio of 2 means Infosys has twice the amount of short-term assets compared to its short-term liabilities, indicating good liquidity.
6. Quick Ratio
The quick ratio, also known as the acid-test ratio, is a stricter measure of liquidity. It excludes inventory from current assets, focusing only on the most liquid assets.
Formula: Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Example:
If Maruti Suzuki has current assets of ₹15,000 crore, inventory of ₹5,000 crore, and current liabilities of ₹7,000 crore, the quick ratio is:
Quick Ratio = (15000 – 5000) / 7000 = 1.43
A quick ratio above 1 indicates that Maruti Suzuki can cover its short-term liabilities without relying on the sale of inventory.
7. Earnings Per Share (EPS)
EPS is one of the most important metrics for investors. It measures the profit allocated to each outstanding share.
Formula: EPS = (Net Income} – Dividends on Preferred Stock) / Average Outstanding Shares
Example:
If ICICI Bank has a net income of ₹10,000 crore and 1,000 crore shares outstanding, the EPS is:
EPS = 10000/1000 = ₹10
This means each share of ICICI Bank generated ₹10 in profit over the period.
8. Dividend Yield
The dividend yield shows how much a company pays out in dividends each year relative to its stock price.
Formula: Dividend Yield = {Annual Dividends per Share/Price per Share} X 100
Example:
If ITC pays an annual dividend of ₹10 per share and its stock price is ₹300, the dividend yield is:
Dividend Yield = {10/500} X 100 = 2%
This means investors receive a 2% return on their investment through dividends.
9. Net Profit Margin
Net profit margin indicates how much profit a company makes for every rupee of revenue after all expenses have been deducted.
Formula: Net Profit Margin = {Net Profit/Revenue} X 100
Example:
Assume TCS generates ₹50,000 crore in revenue and has a net profit of ₹10,000 crore. The net profit margin is:
Net Profit Margin = {10000/50000} X 100 = 20%
This means TCS retains 20% of its revenue as profit after all expenses.
Understanding these key financial ratios can help investors assess a company’s financial strength, profitability, and growth prospects. Whether you are evaluating stocks like Reliance, Tata Motors, or Infosys, financial ratios provide valuable insights into whether a stock is fairly priced, the company’s efficiency, and its potential as a long-term investment.
If you want to learn more about fundamental analysis, Definedge Library has an entire library of Fundamental terminologies.