You must have heard from experts in order to invest in fundamentally strong stock, one should know to analyze the balance sheet. Financial Ratios are one of the most important aspects of balance sheet.
It helps to determine the overall health of a company. But as a beginner it can become tedious job to do the fundamental analysis of a company.
But no worry, financial ratios are here to help you to make better decision in buying stocks.
Here is a pro tip before diving into ratios don’t forget to compare all of the following ratios with its peers.
1. ROCE (Return on Capital)
It is calculated by the formula,
ROCE = EBIT / Total Assets – Total Liabilities
It is basically the indicator of whether the company is profitable or not. You can compare the ROCE of one company with another.
Higher the ROCE better it is.
If the company is manufacturing the product at 100 rupees and selling at 130 rupees then the ROCE of company would be 30%.
In short how much money company is making on invested money is none but ROCE.
High ROCE business makes high profit so it is advised that to invest in high ROCE business.
EPS = Net Profit – Preferred Dividends/No. of Common Shares
EPS is Earning Per Share. As the name suggest it tells how much money company is making per its share available in market.
Higher the EPS better it is. It is one of the important metrics as it is used to calculate the PE ratio.
In future if the company split the share in 2:1, which means that number of shares will double but it’s value will be half.
As a result, the EPS will also be halved. If the company announces for the buyback, then its EPS will also increase.
ROE = Net Profit / Shareholders Equity
It is Return on Equity. Whenever you invest in something you expect specific returns, ROE does the same.
It indicates the amount of return shareholders make on their money.
Company with higher roe shows that company is giving high returns to its shareholders.
PE = Price Per Share/EPS
PE is Price to Earnings Ratio. If the PE ratio is low then the company is said to be undervalued. However, there might be some reasons behind its low price.
It doesn’t mean that if the PE is higher then you should avoid buying stock.
When the PE is higher it shows the reputation of company in the market or confidence of investors in its future prospects.
To make it simpler if the PE of the company is 15 rupees then it means company is earning 1 rupees but people are ready to pay 15 rupees for it.
To know whether the share is undervalued or overvalued then you can compare its PE with its peer.
5. DEBT TO EQUITY
Debt To Equity = Total Debt / Total Equity
It shows that how much of company takes the debt over its equity; It is advised that company shouldn’t have high debt.
If it so then company will have to pay most of it profit in the form of interest.
Many times, company takes debt to grow their business. But in adverse condition company might not sustain, hence it is advised that to invest only in low or zero debt companies.
Along with above ratios, ratios like Price to Book, Dividend Yield are also most important.
Yes, all of these ratios are very helpful but one should freshly calculate all of the ratio on the quarterly basis.
Lastly, never ever invest your hard-earned money just on the basis of single ratio.