Financial Ratios Summary for Equity Valuation.

A Quick Refresher on the Important Ratios for Financial Analysis.

Financial analysis is a key field in Finance and Accounting. Through it, we find the so-wanted intrinsic value that tells us whether to buy or sell a stock. Below is a refresher of the main valuation metrics used to make decisions within the equity investment framework. For trading and investment performance measurement, you can refer to this article:

Profitability ratios

  • ROE -Return on Equity
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Return on Equity measures the company’s net income relative to the shareholders’ equity. It is a very simple metric to evaluate the returns. Generally, when we calculate a company’s ROE, we tend to compare it to the industry’s average so that we know its position relative to its peers. It is also useful to monitor the evolution of the ROE over the years and see whether it’s gradually improving or deteriorating.

  • ROA -Return on Assets
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Return on Assets measures the profitability of the company relative to the total assets. It is an indication on how well the company is doing compared to the assets it invested. The higher this ratio is, the better because it means a more productive use of its resources. It is worth-mentioning that different sectors and industries have varying ROA ratios.

  • GPM -Gross Profit Margin
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A profitability ratio to compare the gross profit to the total revenue. Hence, a measure after deducting the cost of goods but before all other expenses. A high gross margin ratio is seeked as this is seen as a good way to manage costs. It is better to compare this ratio between companies of the same sector due to the different cost structure across sectors and industries.

  • NPM -Net Profit Margin
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The net profit margin is simply a view on the net income generated relative to the total revenue generated. It measures the percentage of net profit that the company generates after paying all expenses including taxes. This ratio is typically monitored over the years to detect patterns and trends.

Liquidity ratios

  • Current ratio
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The current ratio measures the ability of the company to meet its short-term obligations (less than a year). It is simply the total current assets (short-term) over the total current liabilities (short-term). If a company has a current ratio of 3.5, it means that it can pay off the current liabilities 3.5 times using the current assets.

  • Quick ratio
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The quick ratio is the company’s ability to pay the short-term (current) liabilities that are convertible into cash. The formula as described above doesn’t use all of the total current assets. It focuses on cash, short-term securities, and accounts receivable. The quick in the ratio’s name comes from the fact that the assets in the nominator can quickly be converted to cash.

  • Cash ratio
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This ratio checks the ability of the firm to pay the short-term debt with the cash it has. It is clear that this ratio narrows the scope a bit since the last two similar ratios as it forces us to measure the company’s liquidity using strictly cash and cash equivaletns. The higher the better as it implies an ease in paying off debt. However, a very high cash ratio also means that the company is not efficiently utilizing its cash (investing it). Therefore, some consider a value between 0.5 and 1.0 as an acceptable ratio.

  • Operating cash flow ratio
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From the formula, it is a straightforward ratio that measures the firm’s ability to pay off the current liabilities using the cash flows from operations. It is a very important ratio and the higher the better (you are generating more than enough to cover your current obligations).

Efficiency ratios

  • Inventory turnover ratio
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The inventory turnover ratio can be seen as a measure of how many times the company sells and replaces the stocks during normally a fiscal year. The average inventory is simply the value beginning of the period (or year) and the value at the end of the year divided by two.

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  • Inventory turnover days
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This ratio calculates the number of days it takes on average to sell the inventory. Let’s take the below example to clarify things up:

Company A had a cost of goods sold of $5,000,000 last year, with the ending year’s inventory value at $500,000 and a beginning of year’s inventory at $250,000. The inventory turnover ratio is therefore:

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Making the inventory turnover days:

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So, on average, company A requires 27.38 days to sell the inventory.

  • Accounts receivable turnover ratio

The accounts receivable turnover ratio can be seen as a measure of how many times the company collects its receivables on average during normally a fiscal year. The average accounts receivable is simply the value beginning of the period (or year) and the value at the end of the year divided by two.

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  • Accounts receivable days
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This ratio calculates the number of days it takes on average to collect the sales on credit from customers. A lower ratio is naturally desired.

  • Accounts payable turnover ratio
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The accounts payable turnover ratio can be seen as a measure of how many times the company pays its account payable on average during normally a fiscal year. The average accounts payable is simply the value beginning of the period (or year) and the value at the end of the year divided by two.

  • Accounts payable days
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This ratio calculates the number of days it takes on average to pay the purchases on credit from creditors. A lower ratio is naturally desired.

Leverage ratios

  • Debt ratio
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Also known as the debt to asset ratio is one of the basic leverage ratios that shows the percentage of assets being financed with debt. Obviously, the higher the ratio is, the riskier the company becomes. It is commonly used in credit analysis to determine the debt situation of a company and its ability to repay its obligations (a measure of solvency).

  • Equity ratio
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The equity ratio is the total shareholder’s equity relative to the total assets. It is the portion of the owners to be claimed in case of liquidation of the company.

  • Debt-to-Equity ratio
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The debt-to-equity ratio measures the weight of the total debt relative to the shareholders’ equity. It is a gauge as to whether the company is using debt or equity financing for its business. A higher ratio implies more debt financing and thus more risk in running its operations. Although leverage is desired by certain types of companies and offers tax advantages, it is generally considered risky.

Valuation ratios

  • P/E ratio
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This is probably the most known valuation ratio. As it compares the share price to the EPS, it is also a measure of market sentiment relative to earnings. High P/E companies are generally seen as growth stocks or overvalued depending on their special situation. Low P/E companies are often seen as value stocks or undervalued. A $100 stock with a low P/E can be seen cheaper than a $60 stock with a high P/E from an earnings perspective.

  • P/S ratio
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This is ratio shows how much an investor is willing to pay per $1 of company sales relative to one stock. Similar to the P/E ratio, a low value is a sign of undervaluation while a high value is a sign of overvaluation. The disadvantage of this ratio is that it disregards the fact that the compayny is not making money (i.e. negative net income). It’s also best used with companies from the same sector.

  • P/CF ratio
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This is a self-explanatory ratio and is how much cash is generated per its share price. As cashflows are not manipulated that easy, some professionals prefer this ratio to the P/E ratio. A low ratio may signify an undervalued company while a high ratio may signify an overvalued one.

  • EV / EBITDA ratio
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A comparison between the Enterprise Value (which is found using the formula below) and the EBITDA measure. It is used to compare the relative value through different businesses.

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This ratio can be used to find a company’s intrinsic value and this is by comparing to the industry average EV/EBITDA, then by comparing to the company’s ratio.

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Written by

Institutional FOREX Strategist | Trader | Data Science Enthusiast. Author of the Book of Back-tests: https://www.amazon.com/dp/B089CWQWF8

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