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We often come across many different financial ratios with complicated names. We are also confused about what types of indicators to use in a particular condition. In this section, we will discuss two types of financial ratios: debt ratios and valuation ratios. Never try to analyze a company with just one type of ratio. Using multiple ratios and comparing them with peer metrics over a period of time gives us the big picture of a business. Let’s start!
For a business, debt (leverage) is like a double-edged sword. They can expand their business and improve their sales with the help of loan funds. However, if not used wisely, the interest paid on these loans can eat away at a company’s bottom line. It can also lead to a tight squeeze on cash for future operations. Leverage ratios can be classified as follows:
- Debt to Equity Ratio
- Debt to Asset Ratio
- Financial Leverage
- Interest Coverage Ratio
Debt to Equity Ratio
Equity is the value that belongs to the shareholders of the company. It is calculated by subtracting liabilities from the value of assets. The debt-to-equity ratio tells us how much debt a company currently has to its equity. We can find a company’s total equity in its balance sheet. By adding up the short-term debt and the long-term debt, we get the debt.
Debt/equity ratio = total debt/total equity
2. Debt to Asset Ratio
In this ratio, we replace the total equity of the previous ratio with the total assets of the company. By converting the results into a percentage, we can analyze the proportion of a company’s assets secured by debt.
Debt to Asset = Total Debt / Total Assets
3. Financial Leverage
Financial leverage adds another dimension to a company’s debt analysis. Although the formula does not include debt, it appears that assets are present for every unit of equity. The formula is:
Leverage = Total assets / Total equity
4. Interest Coverage Ratio
The interest coverage ratio tells us how much a business can earn relative to paying interest. It is also known as the debt service ratio.
Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Financing Expense
EBIT is calculated by adding finance costs (listed as an expense) to pre-tax profit (PBT).
As stock market investors, it is ideal to buy stock in a company when it has a cheaper valuation. Valuation is the process of determining the true value of an asset or business. For example, real estate prices for a particular plot of land increase when there is an announcement of a new urban area or a tourism project. People who buy plots earlier at a cheaper price tend to take advantage of higher property valuations. Similarly, investors can measure the value of each stock they invest in.
Price/Earnings Ratio (P/E)
The price-to-earnings ratio gives you an insight into how much stock market participants are willing to pay for the stock for every Rs 1 in profit the company generates. EPS can be easily calculated by dividing a company’s net profit by the total number of shares. Each industry/sector has a different valuation margin. Therefore, a standard P/E range cannot be established for all stocks.
Price/earnings ratio = current market price/earnings per share (EPS)
Price to Sales (P/S) Ratio
We have used earnings per share (EPS) to calculate the P/E ratio. However, EPS can be affected by factors such as changes in the tax system, new accounting rules, liquidity. one-time calculation, etc. To overcome this, we can look at the total revenue of a company to find out its valuation. Revenue per share can be calculated by dividing a company’s operating revenue by the total number of shares.
Price-to-sales ratio (P/S) = current market price / sales per share
Price/British Pound (P/B) Ratio
Assume a company goes out of business after liquidating its assets and all liabilities. Any final funds remaining in the company must be distributed to its investors. This value is called the book value of a business. The sum of equity and cash reserves on a company’s balance sheet is its carrying amount. Divide the book value by the total number of shares to get the book value per share.
Price-to-book ratio = current market price / book value per share
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