10 important financial ratios & formulas explained

Financial ratios & formulas are primarily tools for turning the data contained in financial statements into information used by an analyst or an investor to better understand what is happening in a company. It is the relationships between the various figures of financial statements to help a financial analyst to evaluate a company’s financial strength or weakness, and to get insights into possible stock market performance in an efficient manner. Financial ratios can typically be grouped into six major ratio types:

Market value ratios – Market value ratios measure how cheap or expensive the company’s stock
is based on some measure of profit or value. P/E, P/B, Enterprise value comes under market value ratios

Liquidity ratios – Liquidity ratios measure the company’s ability to pay off short-term debt
obligations. Cash Ratio, acid test, Current ratio are some of the common liquidity ratios.

Performance ratios – Performance ratios (also known as activity ratios) measure a company’s ability to generate sales and derive profit from its resources. Average Collection Period, Inventory Turnover, Total Asset Turnover.

Cash flow ratios– Cash flow ratios measure how much cash is generated and the safety net that
cash provides to the company to finance debt or grow the business. Cash Flow Coverage, Dividend payout ratio, Operating cash flow

Profitability ratios – Profitability ratios can be thought of as the combination of many of the other
more specific ratios to show a more complete picture of a company’s ability
to generate profits. Return on Assets, Return on Equity etc.

Debt ratios – Debt ratios measure the company’s overall debt load and the mix of equity
and debt. Debt to Equity ratio, Interest coverage, Asset turnover etc.

Every type of financial ratios is efficient to conclude about the company’s performance but there are 10 important financial ratios that cannot be ignored

These 10 key financial ratios and formulas list explain the important points to determine the strength of the company’s performance.
1. Altman Z Score – The Z-score formula used to predict the probability that a firm will go into bankruptcy. For investors, whose first priority is safety which means it is for sure that the company with high Z Score can sustain in a bad time.

2.Compounded Sales Growth – Growth is one of the important parameters to understand the company’s competitive strength. If you find the company sales improving year by year then you are on the right way to invest in the right company

3. Compounded Profit growth – In this competitive world, the company’s profit margins are decreasing due to high competition in almost every domain but if any company can generate big profit by selling their products then that company definitely has an advantage over competitors in terms of product, price, services, brand name, etc.

4. Return on Equity – ROE is a measure of how much profits the company is generating from the entrusted money from an investor. High ROE is the result of skilful management efforts to benefit their stakeholders. The formula is:-

                             Return on equity = Net income / average shareholders’ equity

5. Return on Capital Employed – ROCE is a measure of how efficiently a company is using its capital to generate earnings growth. 

6. Price to Earnings ratio – Price to Earning ratio is the ratio of the company’s current share price to its earnings per share. It helps to analyze the company value concerning its competitors.

7. Interest Coverage Ratio – The interest coverage ratio (ICR) is a measure of a company’s ability to afford its interest payments. Interest coverage ratio determines the company’s growth if their earning is utilizing less in paying debt interest.

8. Inventory Turnover ratio – Inventory consists of the materials from which the goods will be made; it will be used up and ultimately become part of the finished goods that will be sold. Inventory may include raw material, partially completed goods, known as work in progress or WIP, or finished goods waiting to be sold. The inventory turnover ratio tells you how long it takes to clear the goods from the warehouse. The formula to calculate the inventory turnover ratio is 
                         Inventory Turnover ratio = (Average Inventory/cost of goods sold)*365 

9. Earnings Yield – The earnings yield is the opposite of the P/E ratio and gives a clear idea about the rate of return on your investment. Earnings Yield is a tool that helps to compare the different investment plans such as bonds, fixed deposit schemes, company share to determine that which is a good deal to invest to get higher a rate of return on investment.

10. Account receivable turnover (Receivable turnover) – It comes under the performance ratio. The accounts receivable turnover measures the number of times receivables
are converted into cash in a given period.

Accounts receivable turnover =       Sales

The higher the accounts receivable turnover ratio, the better the company is at converting receivables into cash. A decline in the turnover ratio could mean either a decline in sales or an indication that the customers are taking a long time to pay for their purchases. The company can improve the turnover ratio by many methods; the most popular is by offering a discount if the customers pay their outstanding balance earlier; for example, within 30 days of the sale.

Various other types of financial ratios are useful depending on one’s investment style and his/her return expectation from the market. For eg., if someone is interested in regular income in the form of dividends then high dividend yield plays an important role in fulfilling the requirement for high dividends.

These 9 fundamental ratios are not very useful to analyse the industries which either require huge debt for setup or involved in finance. It is better to use different types of financial ratios list to invest in industries that require huge debt for setup or finance-related companies. Not only for the purpose to invest in big setup or financial companies although it is important to regularly study the various other types of financial ratios to suit with the desired returns from the market. One thing is for sure that these 9 important financial ratios help a long term investor to find the sound company to become a shareholder for the longer term.

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