Financial ratios to analyze stocks4

Every day, you see the Sensex rise or fall hundreds of points. This fluctuation may worry many

investors. In such turbulent times, it is important to select quality stocks. That way, you can be rest

assured through the temporary ups and downs; your stock’s future is secure.

So how do you select quality stocks? Simple – choose a company that is expected to grow over the

next decade or so. This can be done by looking at four key financial ratios.

Profitability Ratios: Nothing matters more to an investor than a company’s profits. But you often

need to go beyond the final profit numbers to gauge the actual profitability. It can so happen that a

company posts great profits for a short term, but is unable to do so consistently. This means its

business model is not profitable. Some common profitability ratios are Profit Margins, Return on

Equity (RoE), Return on Investments (RoI), Return on Assets (RoA), and so on.

#1

Operational Efficiency Ratios: A company’s profit depends on two factors – revenue and cost. It is

important that companies minimize cost as much as possible to maximize profits. When a company

does this, it is being efficient. There are many financial ratios which gauge this operational

efficiency by comparing various costs with revenue and profits or understanding the time taken to

produce goods or sell ready products. Some even measure the time taken by clients to pay money

or the payment cycle for suppliers. These need to be looked at together. One single ratio cannot

give the whole picture. Efficiency ratios include the Operating Expense Ratio, Inventory Turnover,

Accounts Receivable Turnover, Total Asset Turnover and Accounts Payable Turnover.

#2

Liquidity Ratios: Companies buy supplies, use them to produce goods, distribute it in the market,

and sell to customers. This process often takes long. So, the company does not pay suppliers

immediately. Similar, revenue too does not stream in immediately after sales. If the two payment

cycles do not match, the company could have a cash crunch. It may then have to borrow

unnecessarily, eating profits. Moreover, such a business model may not be sustainable in the long

run. Liquidity Ratios like Working Capital, Quick and Current Ratios, etc, help in this regard—they

measure how much cash the company has on a regular basis.

#3

Leverage Ratios: A certain amount of debt is necessary for every company—it can often signify

growth and expansion. However, too much debt is bad news. It can be the death of a company. This

is why it is important to understand debt. Leverage Ratios helps measure how much a company is

borrowing and if it will be able to repay it. Inability to repay means high risk. Some common ratios

are the Debt to Equity and the Interest Coverage ratio.

#4

1. Simple Investing Ratios You Need To Know

2. Return

ratios continue to fall for Indian firms, shrinking gap with rest of the

world

IMPORTANT LINKS:

33.86%Another important metric is the Return on Capital Employed. It indicates the efficient use of funds

for operations. In the last decade, RoCE for the 319 non-finance companies out of the BSE 500 hit

a peak of 33.86% in FY07, according to a Livemint report. Since then, it has continually fallen. This

year, it is expected to stand at 14.81%. This shows companies are unable to use capital funds

efficiently as demand remains poor, and cost of funds is high.

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