Question

How to interpret the financial ratios between company And industry

Answer 1

To understand the performance of a company in a particular industry normally the company's financial ratios are compared with the other companies in the same industry that are performing well so that we can judge the financial health of the company. Basically, a lot of financial ratios can be considered for comparison but the few most important ones are :

1) Earnings per share (EPS): Earnings are basically the Net income which is left after accounting for all the expenses and losses. This is what is available to the equity shareholders after all claims on profit have been met. Comparing the EPS of a company with the EPS of other companies in the industry helps in determining the performance of the company. So, a higher EPS is considered desirable as the same can be distributed as dividend and can also be used for investing in growth opportunities if need be.

2) Price to Earnings Ratio (P/E Ratio): This talks about the price that one pays for a dollar of earning. It is helpful in finding out whether the price of the company's share is undervalued or overvalued. It can also be used to make a comparison with the industry's average P/E Ratio and market's P/E Ratio in general to make a decision regarding how the company is being valued by the investors.

3) Debt to equity ratio: It talks about how much debt is involved vis-a-vis a company's equity. A well-leveraged firm is believed to be meet the objective of maximization of shareholder's wealth which also reflects on the optimal capital structure of the firm. At the same time, comparing it with the other companies in the industry also tells us about their capital structure and how well they are financed. An extremely high debt-equity ratio can pose a threat to the survival of the company. Usually, 2:1 is considered an ideal ratio.

4) Return on Equity: Every investor seeks return out of his investment and the higher the better it is. It is normally used to compare the profitability of various companies in the industry. It is an indicator of how well the management of the company is doing in comparison to other companies in the industry.