Question

What are the major types of financial ratios used to measure a company's financial performance or health? Discuss at least 5 indicators/ratios and give examples in your discussion. The more you write and give examples, the more points you score

Answer 1

1. Working Capital ratio - This is defined as the ratio of a company's current assets to its current liabilities. It shows that how easily can a company convert its current assets into cash to pay its short term loans.

Example - A company having current assets of $4 Million and current liabilities of $2 Million will have a working capital ratio of 2:1. Which is considered as pretty attractive. However, if there is another company which has a working Capital ratio of 2:1. The more attractive company will be the one with more cash in the current assets.

The more working capital ratio, the better it is for the investment.

2. Quick ratio - In this ratio, inventory is not considered to be quickly convertable to cash to pay off the current liabilities. Hence, inventory is subtracted from the current assets to calculate the ratio. The more is the ratio, the better it is for the company. Quick ratio is also known as the acid test of the company and is equal to (Current assets - Inventory) / Current liability.

Example - A company with $4 million as current assets out of which $1 million is the inventory and the current liabilities worth $2 Million, will have a quick ratio of (4-1)/2 = 3/2 or 1.5:1. This is still a good figure for the company. If the ratio is less than 1 then it will be a good choice to invest in a company with 1.5.

3. Price Earnings ratio - It is calculated by dividing the price of a share of the company's stock by the earnings per share of the company. It is also called as P/E ratio. It shows how much does an investor has to spend to earn the value of one unit of the price.

Example - Let us suppose that the share price of a company closed at $50 and EPS for last 12 months averages at $5. Then P/E ratio = 50/5 = 10. It states that investor will earn $1 for every $10 invested in the shares of the company. The lesser P/E ratio shows that the returns are better.

4. Debt - Equity Ratio - It is defined as the ratio of total loans which includes both short term and long term loans to the total book value of the shareholder's equity of the company.

Debt Equity Ratio = (Short term loans + Long Term loans) / Shareholder's equity

Example - If a company has $ 50 Million worth of loans and the shareholder's equity values for $25 Million, Then Debt to Equity ratio is 50:25 = 2:1 .The absolute value of this ratio is analysed as per the industry norms in which the company works in. The more is the debt, the worse it is for the company.

5. Return on Equity - Return on Equity is an important ratio for the common shareholder to know the profitability of the capital they are investing in the company. It is calculated as given below:

Return on Equity = (Net profits after tax deductions - preferred dividends) / Total Equity

Example - Let us say that the net earnings after tax is $1.5 Million and $0.5 Billion is the preffered dividends. The common equity is $ 5 Million. Hence, the Return on Equity would be 20% which is a good return on equity for an investor. It is calculated in the percentage terms.