Key Financial Ratios

In the previous chapters, we discussed basics of income statement and balance sheet. These statements can sometimes be too lengthy to read and understand. It is also hard to deduce inferences about the company just by looking at raw numbers. Hence in order to quickly analyze all the raw data derived from income statement and balance sheet and to make our investment decision we use financial ratios. Some of the important ratios are explained below. We will continue using the example of ABC Inc.

RoE

Return on Equity

It is the income generated per unit of equity invested, i.e. how much returns shareholders/investors are getting on the money invested by them in the company. Please note that not all returns will be credited to the investor’s account. The company might decide to return only some amount as dividend and retain the rest for future investment purpose.  However since all profits generated by the company, technically belong to the investors we use the same for return calculation.

                  ROE = PAT (income statement) / Total shareholder’s equity (balance sheet)

It is usually expressed as a percentage. In case of ABC Inc, it would be 24% (ROE = 12000/50000 = 0.24)

Let’s consider an example to understand how the ratio can be used by individual investors. Suppose you have Rs 5000 and are contemplating whether to invest in ABC Inc or a bank fixed deposit. Bank is offering 10% returns for a one year fixed deposit. However you are aware that ABC Inc. generated 24% returns last year. If you believe that ABC Inc. will continue to perform well and be able to sustain its profitability, then the company will probably generate 24% returns next year as well. Hence it would make sense to invest in ABC Inc. compared to bank fixed deposit.

One argument against investing in ABC Inc. is that past performance doesn’t guarantee any future performance and that the company might not generate high returns next year. But suppose ABC Inc. has continuously generated ROE of 24% over the previous 5 years, then there is a good chance that company might do this in the future as well. One should always look at the ROE history of a company to understand how much returns can be expected in the future. ROE also helps in comparing two different companies. However please make sure that  only apples are compared to apples, i.e. similar companies from same sectors should be compared to each other.

Dividend Yield

Let’s assume, ABC Inc is listed on National Stock Exchange (NSE) and has a stock price of Rs 100. Total number of shares issued by ABC Inc is 500. Dividend yield is defined as the ratio of dividend per share to price per share (commonly expressed as %).

                                                   Div. yield (%) = DPS / Price

            where DPS is total dividend declared by the company/total number of shares

In case of ABC Inc, DPS = 2000/500 = 4. Hence dividend yield of ABC Inc = 4/100 = 4%.

When you buy shares of any company, there are two different types of returns that you can expect, capital gains and dividend income.

Suppose, you buy one share of ABC Inc today at a price of Rs 100 and sell it back after one year at a price of Rs 125. In this case, you will generate a capital return/price return of 25% (125/100-1). Suppose ABC Inc. declares a Rs.4 dividend during this period your total returns will be Rs.29 (price return + dividend return). It’s very important to understand that when you invest in shares, your total return is not just the price return, but price plus dividend return. Dividend yield is a measure of the second type of return. It is an indication how much dividend can be expected on the investment. In ABC Inc.’s case an investor can expect to get Rs 4 as dividend on an investment of Rs 100.

As discussed earlier, an early stage company might not pay dividends and might retain its profit for future investment purpose. So in this case, dividend yield will be zero. But we know that dividend is just one part of the return. Stock prices of growth companies grow fast in response to company’s higher growth rate, thereby generating substantial capital gains.  One should always consider dividend yield when investing in a company’s stock, as it can be significant part of the return that might be generated. High dividend yield stocks are a good investment avenue to supplement your income needs.

NPM

Net Profit Margin

It is defined as the ratio of net income generated in a year to total sales / revenue.

                                                            NPM = PAT / Sales

In case of ABC Inc, NPM is 12% (12000/100000=0.12). This means that for every Rs 100 worth of auto parts sold by ABC Inc, a net income of Rs 12 was generated. As explained in our article on Income statement, we know that we need to deduct many items from total sales / revenue, to arrive at net income number. Items like cost of goods sold, interest, taxes and others are subtracted from total sales / revenue, to finally arrive at net income. The NPM ratio tells us how efficiently a company is converting its sales to profit. Better management of taxes, raw materials, inventory and operational efficiency can lead to substantial profits. Thus in case of two different companies of same size which operate in the same sector, the company which has higher NPM is more efficient, as it can generate more profits by selling the same amount of goods.

Dividend Payout Ratio

This ratio tells us how much of profit is distributed to shareholders/investors in the form of dividends. It is calculated by dividing total declared dividends by PAT/net income.

Payout Ratio = Total dividends / PAT

In case of ABC Inc, the ratio would be 16.67% (2000/12000=0.1667). It tells us that only 16.67% of the profit generated by ABC was distributed to investors and rest was invested back in the company. As discussed previously, early stage companies tend to pay less dividends and reinvest more as they have more opportunity to grow. On the other hand, mature companies pay more dividends out of their profits as they have fewer growth opportunities. So early stage companies might have small payout ratios compared to large companies.

Apart from financial statement ratios, there are many other ratios like PE ratio and PB ratio which help us in making a better investment decision. In the next chapter we have covered some key ones.