PART-2

In the first part of this article we have already discussed about the six important financial ratios ,out of eleven financial ratios. In this article we will be discussing about the other five financial ratios.

So, without wasting much time we should start discussing about the remaining five financial ratios:

1. RETURN ON EQUITY:

The main aim of an investor is getting the best possible returns on a stock. Return on equity measures the earning that gives an idea about the return that an investor gets from the business. And overall earnings of that company. It helps investor compare profitability of companies in the same sector. The value of this ratio highlights the capability of the management. Return on equity is net income divided by shareholder equity. If the value of return on equity is 15-20% it is considered to be a very good value. The company which shows high growth generally have a higher value of return on equity. And the main benefit arises when earnings are reinvested to generate a more significant return on equity. However, a rise in debt will also be reflected in high value of return on equity. An investor expects leveraged companies to exhibit inflated return on equity.

The main benefit arises when earnings are reinvested to generate a more significant return on equity. However, a rise in debt will also be reflected in high value of return on equity. An investor expects leveraged companies to exhibit inflated return on equity.

It is especially used for comparing the performance of companies belonging to the same sector. ROE signifies the capability of management to generate income from the equity available to it. If the ROE of a company is around 15-20%, it means the company is performing good. A stock’s valuation also depends significantly on the ROE.

2. INTEREST COVERAGE RATIO:

It is earnings before interest and tax, or EBIT, divided by interest expense. It indicates about the solvency of a business. And gives an idea about the number of interest payments the business can service solely from operations. One can also use EBITDA in place of EBIT to compare companies in sectors whose depreciation and amortisation expenses differ a lot. And, one can use earnings before interest. So, after tax if one wants a more accurate idea about a company’s solvency.

If a stock has an interest coverage ratio above 1. It signifies the company is doing good. But, if the value is below 1, it means that the company is facing difficulties in it’s operation. It tells about the generation of cash for running the company. If a company has good history of earnings, it presents a better image of itself in front of the investors.

3. CURRENT RATIO:

This shows the liquidity position, i.e how equipped is the company in meeting its short term obligations with short term assets. A higher figure signals that the company’s day to day operations will not get affected by working capital issues. A current ratio of less than one is a matter of concern. The ratio can be calculated by dividing current assets with current liabilities. Current assets include inventories and receivables. Sometimes companies find it difficult to convert inventory into sales or receivables into cash. This may hit it’s stability to meet obligations. In such a case, the investor may calculate the acid-test ratio, which is similar to the current ratio but with the exception that it does not include inventory and receivables.

The current ratio is helpful only when the companies of same sector are compared. This is because the mode of operation of different sectors differ from each another.

4. ASSET TURNOVER RATIO:

It shows how efficiently the management is using assets to generate revenue. The higher the ratio, the better it is, as it indicates that the company is generating more revenue per rupee spent on the asset. Experts say the comparison should be made between the companies of same sector. This is because the ratio may vary sector to sector. In sectors such as power and telecommunication , which are more asset heavy , the asset turnover ratio is low , while in sectors such as retail , it is high ( as the asset base is very small ).

Asset turnover ratio is a financial ratio that measures the efficiency of a company’s use of it’s assets in generating sales revenue or sales income to the company. The companies which have low profit, they have high asset turnover. While the ones with high profit margins have low asset turnover.

5. DIVIDEND YIELD:

It is dividend per share divided by the share price. A higher figure signals that the company is doing well. But one must be wary of penny stocks ( that lack quality but have a high dividend yield ).Companies benefiting from one time gain or excess money that is used by the company to pay dividend must be avoided. Similarly, a low dividend yield may not imply a bad investment as companies may use the extra cash to earn more returns for the shareholders in long run. A high dividend yield however could signify a good long term investment as companies dividend policies are generally fixed in the long run.

The dividend yield ratio of a company is also the company’s total annual dividend payments divided by it’s market capitalisation. Generally, investors opt for the stocks which have a higher dividend yield. A high dividend yield can be taken as a signal that the stock is underpriced. Or in coming times the dividend will decrease.

Similarly, a low dividend yield can be taken as a symbol for the stock being overpriced or the dividends might increase in future. Different kinds of investors have different perception about the value of dividend yield.

Some consider high yield a good one, while the others consider it as bad. The investors who consider it bad, want the company to invest that amount in expansion of the company.

While financial ratio analysis helps in assessing factors such as profitability, efficiency and risk, added factors such as macro economic situation , management quality and industry outlook should also be studied in detail while investing in a stock. Though this is not a foolproof method. It is a good way to run fast check on a company’s health.

For part 1 click here