How Financial Ratios Help Us Understand Companies

1. Return on equity (ROE)

To understand return on equity, we should first understand the term equity.

What is Shareholder Equity? This is the company's net worth. If the company sold everything it owns (its assets) and paid off everything it owes (its liabilities), the money left over would belong to its owners or shareholders. That remaining amount is the Shareholder Equity.

Return on equity hence, as the name suggests, is a measure of how well a company is returning profits out of shareholder equity. It compares a company's final profit (net income) to the value belonging to its owners (Shareholder Equity). It is simply the ratio of these two terms, expressed in percentage.

Return on equity thus tells us the amount of profit the company generates for each dollar of a shareholder’s ownership in the company. In other words, if suppose your investment is worth $100 in a company, then roe tells you how much net profit the company earned for you from that $100.

A word of caution: while roe is a useful and important metric but it can be misleading for companies that have excessive debt on their books. As you can see from the formula above, a higher debt (or liability) will reduce Shareholder Equity (the bottom number). This can make the ROE percentage look artificially high, even if the company's performance isn't actually that strong.

Nonetheless, a return on equity value above 15% is considered good for non-debt companies. Though it is advisable to compare roe of a company with peer companies of the same sector.

There is a more sophisticated manner to calculate roe using a method called DuPont Analysis. You can learn more about that here if you are interested.

2. Return on capital employed (ROCE)

ROCE is another key ratio to measure profitability of a company. It compares the operating profit of a company but, alongwith shareholder's equity, it also takes into account the liabilities owed by the company.

In financial jargons, capital employed means all capital, both the owners' money (equity) and the borrowed money (long-term debt).

Thus, unlike roe which only uses equity, roce tells us how well a company is using all its capital (both debt and equity) to generate profits. It is a more reliable metric to measure the capital efficiency, especially for companies that naturally use a lot of debt.

Its formula is

ROCE is a very useful tool to analyse "capital-intensive" companies that need a lot of money to operate – think of industries like oil and gas, energy producers, car manufacturers, and telecom companies.

1. Inventory turnover

What is inventory? Inventory of a company means all the finished goods which are ready but yet to be sold, all unfinished goods which are still in production, and all the raw materials.

Inventory turnover means how quickly a company sells and replaces its inventory within a year. Its formula is-

Inventory days is another term related to the above which some people find more intuitive. It is obtained from dividing 365 (no. of days in a year) by inventory turnover.

Hence, if a company has an inventory turnover of 10, it means they sell and restock their inventory 10 times within a year—roughly once every 36 days (which will be called inventory days).

If a company has a higher inventory turnover when compared with its peers then it indicates that the company is selling its products faster. Its products aren't sitting around getting old, and the company's money isn't tied up in unsold goods. This may also mean the company's products are in good demand.

2. Receivable and Payable days

For most companies, it is unlikely that they will receive instant cash right after making a sale. Receivable days, also called ‘days sales outstanding’, is the average number of days it takes for a company to collect payment after making a sale.

A lesser value means the company is collecting cash faster which then can be used for other activities.

A higher value on the other hand means the company is selling its products/services on credit for much longer duration which can squeeze the cash flow.

Similarly payable days or ‘Days payable outstanding’ tells us the average number of days a company takes to pay its own bills for their purchases, like raw materials from other companies.

Both receivable days and payable days are important measures of liquidity and cash flow. Their ideal values vary by different industries/sectors. For example, a company in the retail sector may have a lower receivable days than a company in the steel sector.

From an investor's perspective, we should monitor two things regarding receivables and payables- 1. any sudden or abrupt change, and 2. how these ratios compare to those of other companies within the same sector.

3. Working capital to sales

To make all the sales in a year, a company has certain assets that are to be used or consumed fully within that year. These assets are called current assets. Some examples are raw materials, unfinished goods, receivable accounts, cash itself or their equivalents etc.

Similarly, a company can also have certain short term debt obligations to fulfil within an year. For example- interest payments, payable accounts etc. These are called current liabilities.

The difference between the two is known as working capital.

Thus working capital essentially represents the net current assets that a company has at its disposal to run its daily operations. It is a measure of a company's short-term financial health.

A positive working capital is favourable as it suggests that the company can cover its short term bills easily.

A negative working capital on the other hand can be a warning sign. The company might struggle to pay its immediate bills without borrowing more. However please note that different industries operate with different working capital needs. For instance, a retail business with quick inventory turnover might need less working capital compared to a construction firm with long production cycles.

A better way to gauge the working capital of a company is to actually compare it with the revenue which is known as working capital turnover.

This ratio actually gives us a better insight. It tells us how much revenue the company is generating for every dollar of money that has to be consumed in the working capital.

1. Debt to equity and Debt to Assets

Both of them look at overall debt levels from slighlty different angles.

Debt to Equity is the more common one. It compares all debt of a company (both short term and long term obligations) with the overall shareholder’s equity of a company.

A lesser value is definitely favourable and a consistent higher value (greater than 1 but excluding financial companies like banks) indicates that the growth or day-to day operations are heavily funded by debt. In other words a higher value means more leverage and hence more risk.

Debt to Assets is another ratio but it compares the debt of a company with its total assets. A ratio of 0.5, for instance, suggests that 50% of the overall assets of a company is funded by debt. Unlike debt to equity, debt to assets is less common, although personally I find it to be more intuitive.

2. Interest coverage Ratio, Current Ratio, Quick Ratio

All these 3 ratios, with some minor differences, are a measure of how well a company is equipped to meet its short term obligations (current liabilities).

1. Price to earnings (P/E) ratio

PE ratio is ubiquitous, it is the most widely discussed parameter in stock market circles. It compares the market price of a company with its net profit (earnings).

The popularity of the P/E ratio perhaps, lies in its intuition as it is very easy to understand.

A ratio of say, 20 means, the market price of a company is trading 20 times over its present profits.

In other words, if you are buying at this price then it will take 20 years for the profits of the company to catch up or get even (assuming the profits remain same every year, which is a huge assumption in itself).

Personally, I will suggest not to rely on P/E ratio too much especially for high growth companies or startups. It is more useful for mature companies with stable earnings.

2. Price to sales ratio

An alternative to the P/E ratio, although less common. It is the ratio of the market price of a company with its sales or revenue.

There might be cases where a company's profit can look unusually high or low due to one-time events or specific accounting rules (like how they calculate depreciation).

Sales figures are often more stable and harder to manipulate. In such cases, P/S can give a clearer picture of valuation as compared to the P/E ratio.

3. Price to book, P/B ratio

What is Book value? Remember Shareholder's equity we discussed earlier ? Book value is just another term for it. It is just the net assets of a company belonging to its shareholders, a difference between a company’s total assets (what it owns) and its total liabilities (what it owes).

So, Price to book is simply the ratio of a company's market price to its book value.

It is a measure of how much the market is willing to pay for each dollar of the company's net assets. Thus a ratio of 2 for example will mean, the market is willing to pay twice the price of, what the net current assets of the company, are worth today.

Investors sometimes look for companies with P/B ratios lesser than 1, hoping to find companies that are trading for less than what their net assets are worth on paper.