Basics Of Financial Ratio

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Basics Of Financial Ratio

Basics Of Financial Ratio

Financial Ratios : Basics Of Financial Ratio are used to measure the health of any company.  You can also use them to compare any two companies.

ITC, Reliance, Hindustan Unilever, Axis Bank, TCS. Which stock is right to invest?  There are more than 5000 listed companies in India. And this question might often come to your mind that out of these so many companies, in which should I invest? Let’s make this decision of yours easy.

Let’s start this Basics Of Financial Ratio,Liquidity Ratio,Turnover Ratio, Profitability Ratios,Solvency Ratios, Valuation Ratios, Meaning Of Financial Ratio, Equity ratio, Dividend yield ratio, PE ratio. Hello friends, my name is Rksingh  and I work in the investment products team at MoneyPip. Let’s start this Basics Of Financial Ratio and understand the first point, what are the Financial ratios.

Meaning Of Financial Ratio : Like you have your blood report, where it has your cholesterol level, it has your platelet count, it has your sugar level.  Similarly, there are other parameters, but these are such parameters,  which tell you how your overall health is doing. Similarly, Financial ratios tell us about the health of any company, how that company is doing.

Meaning Of Financial Ratio
Meaning Of Financial Ratio

Here, you can judge a company by using the parameters of Financial ratios.  Similarly in a blood report, from cholesterol level you can know how your overall health is, Now the important thing here is, that to measure the health of any company, to judge how good or how bad it is It is always bench-marked with relevant benchmark.

For example, to measure the overall health of India there are two indexes Nifty 50 and Sensex 30. These two indexes measure and track the largest Blue chip stocks of India. And they overall measure the health, how Indian Economy is behaving. So here if you compare financial ratios of any company with Nifty or BSE sensex  then you will know,  how the health of that company is,compared to the overall health of the economy. 

Next we will talk about that by using those financial ratios you can compare any company with its industry. For example,  if we talk about banks, Axis Bank, HDFC Bank, Federal Bank, State Bank of India. For all these companies, NPA which is called Non-performing assets, is an important financial parameter.

So if you see that NPA for Axis Bank is 10% to take the decision on this basis only if Axis Bank is a good company or a bad company, will be wrong. You have to check NPAs for other banks as well. And if NPA of Axis Bank is the least, this means that, that company is the best company in its industry. 

And the second important thing here is Financial ratios,  which we will discuss in this article. On their basis only, we should not judge if I should invest in this company or not. Other financial ratios are there, just like your blood report has many parameters. Cholesterol level is just one of them. 

Similarly the financial ratios we will talk about today,  those are few important financial ratios among many Financial ratios. 

You can check them before taking any investment decision. But you should not invest on the basis of only these ratios. Like I have told you now, there are a lot of financial ratios available in the market. We can divide all these financial ratios into five broad categories. 

Financial Ratios Into Five Broad Categories :

  • Liquidity Ratio
  • Turnover Ratio
  • Profitability Ratios
  • Solvency Ratios
  • Valuation Ratios

Liquidity Ratio

We will take them one by one. The first category is liquidity ratio. Liquidity financial ratios are those ratios which help you and tell you how capable the company is to meet its liabilities in short-term. 

Liquidity Ratio
Liquidity Ratio

It also tells how effective is company’s management  to manage its working capital. 

Turnover Ratio

Let’s talk about second ratio. They are called turnover ratio. Turnover ratios of those ratio usually which tell you how any company is capable of converting its assets or accounts quickly or effectively to sales or to free cash flow. 

Profitability Ratios

Third kind of financial ratios are Profitability ratios. Profitability ratios help you to know how much is the profit generating capacity of any company.  This ratio will also help you if you want to know if any company is loss making or profit making. This ratio helps you there as well. 

Profitability Ratios
Profitability Ratios

Solvency Ratios

Fourth kind of ratios are solvency ratios. These ratios tell you how capable the company is to meet its long-term debt obligations. Usually, long-term is more than one year. So if the company has taken any loans and its interests are due after 1 or 2-3 years. These ratios will help you to know, how able that company is to clear those dues. 

Solvency Ratios
Solvency Ratios

Valuation Ratios

Fifth and the last kind of ratios are Valuation ratios. Valuation ratios tell about any company how attractive that company is as an investment opportunity right now. 

Valuation Ratios
Valuation Ratios

Friends, this way we have categorized all the ratios into five categories. Now, among those five categories, we will talk about top financial ratios,  using which you can measure the health of any company. 

Debt To Equity Ratio

Let’s talk about the first ratio. Debt to equity ratio. It is a solvency ratio.  And this ratio tells you the ratio of the company’s total debt to its equity. 

Let’s take an example here. Total assets of a company are Rs. 100. Out of it, 50 are debt and 50 are equity. Company has financed its total business operations in debt and equity in equal weight. Here the debt to equity ratio will be 50 divided by 50, means 1. Similarly, there may be few companies whose ratio maybe debt is 80 and equity is 20, then it will be 80 by 20, which is 4.

Implications : This way you can measure debt to equity ratio by dividing debt to equity.  Now let’s talk about implications. How you can use this ratio?  When you calculate debt to equity ratio of any company,  generally the lower debt to equity ratio is considered better.

Because it means that the company’s debt repayment capacity is much better. And since the debt is low on its book, interest to be paid by it will also be comparatively less. So, here, financially it is pretty secure. The second thing we should know that the creditors have faith in the company.

Since its debt level is low, So, that it can follow its debt capacity better and it can repay it easily in case of any calamity. Whereas for those companies whose debt level is high, it may happen that if economy is not doing good or it’s in cyclical business, then it may not repay its debt and it may default. 

You might have seen many default cases occurring in Indian markets nowadays. For example IL&FS defaulted in last September. This means that it cannot repay its interest. Recent, very recent example is Altico Capital.  They missed their interest payment of Rs. 20 crores. 

So if there are companies which cannot repay their interest payment, then these companies are not considered good. And there are many such companies where we have to see their debt to equity ratio. 

Important thing here is to compare this ratio within the industry. For example, D/E ratio of textile, cement, manufacturing companies is high  because they need more debt financing as compared to equity. 

Basics Of Financial Ratio
Basics Of Financial Ratio

Whereas the debt to equity ratio of food or IT companies is generally less.  Because there is not much industry specific need of debt financing. Let’s understand through an example. For example debt to equity ratio of Reliance Industries is 40%  versus industry average which is around 65 to 70%. Reliance has used less debt as compared to equity,  in its own industry as compared to its benchmark, as compared to its peers. 

So, here, as you can see Reliance has financed  its business and its growth operations  using less debt. And hence Reliance is less risky because whenever it’s debt is due, it is better capable of repayment of its interest payments. 

Let’s take the second example of Hindustan Unilever. Hindustan Unilever works in FMCG and its debt to equity ratio is almost zero  as compared to industry which is around 20%. Friends, it is very important to know here that debt can be zero. And if debt is zero means all of its operations are financed by equity. As you have seen from the examples here, both Reliance and HUL  are pretty good stocks.

They’ve performed very good over the past five years. But Reliance has debt and HUL doesn’t have debt. So, it’s not necessary that the company with high debt to equity ratio is always bad or it will perform badly. This ratio is more industry specific and hence use it as a benchmark. Like we have compared Reliance’s with industry benchmark and HUL’s with its industry benchmark. 

And we saw that for both of them, ratio is lower than their industry benchmark. and how both companies have performed better in the past 5 years. But it’s better not to compare Reliance and HUL with each other.  Because their industries are different, their industry dynamics are different. 

Hence, their debt requirements are different  and hence the debt to equity ratio comes out differently. Friends, in this Basics Of Financial Ratio Article we write about debt to equity ratio. In the next article of Basics Of Financial Ratio we will cover four more ratios, which are, Return on Equity ratio, Dividend yield ratio, PE ratio  and Free cash Flow to Sales ratio. Make sure to bookmarked to this Moneypip Blogger Website thank You.

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