It’s results season on the Zimbabwe Stock Exchange, albeit delayed by the COVID-19 pandemic. There’s a lot of excitement around results season as investors and analysts alike fight to get a read on just how good the companies are as investments. Also, creditors and other stakeholders will have a keen eye trained on company financial statements to assess their position in terms of liquidity and solvency. We thought it timely to proved a guide to financial ratios and what they mean for the users of the information. We will go through the 5 categories Price, Profitability, Liquidity, Debt and Efficiency.
Price ratios are concerned with giving investors and analysts an idea of how well priced the shares of a company are on the market. They can indicate whether shares are bargains or overpriced.
Price Earnings Ratio
This simply tells you how much you would pay for the earnings you will get. In this case, earnings used is earnings per share from the income statement while the price is the market traded share price.
Price Earning ratio = Price per share/Earnings per share
In simple terms the higher a Price-earnings ratio the more confident the market is in a company. However, Price-earnings ratios need to be looked at compared to other companies or industry averages to get a sense of what exactly they mean. In many cases, a price-earnings ratio over 20 is considered to be overvalued but it can happen.
Price to Book Value
The price to book value ratio looks to discern if the price paid on the share market is justified by the net assets of the business. Again this is focused on ascertaining whether there is a premium or discount and if so how much. It tells us how much confidence the market has in the management of a company. The price is derived from the market while the book value can be found in the Statement of Financial Position or Balance sheet.
Price to Book Value = Price Per Share/Book Value Per Share
It is difficult to give a guideline as to what constitutes a good ratio as the information must be looked at with consideration of the nature of the industry and company.
The dividend yield is a sort of return on investment specific to traded shares. It simply expresses the dividend paid by the company and a percentage of the share price on the market. This will give a measure of how well shares in a company perform for short term income. The dividend per share can be found in the financial statements usually in the notes or following the income statement while the price is the one quoted on the ZSE.
Dividend Yield = Dividend Per Share/Price Per Share
This can be expressed as a percentage and will simply tell you how well your investment paid off. Remember it only looks at dividend income and not capital growth as well.
Dividend Payout Ratio
The Dividend Payout Ratio tells you what percentage of net income (profit) was paid out as a dividend. This is important for two reasons. Firstly how much of the profit you receive as a dividend is important to your pocket. Secondly, it informs on the strategy of the company going forward. Are they retaining money to invest further and earn more returns? Are they in a growth phase or income phase?
Dividend Payout Ratio = Dividend(total)/Net Income
Profitability ratios look at how well a company has employed the assets and resources available to it. The more profitable the better.
Return on Assets
Simply shows how well the assets have been used to create profit for owners of the company. Net income is derived from the income statement while average total assets are the average of current assets and non-current assets balances at the beginning and end of the year.
Return On Assets = Net Income/Average Total Assets
You obviously would a higher return but again consider that some industries are extremely asset-heavy while others are not.
Return on Equity
Similar to the return on Assets it looks at how much profit or income was generated compared to the shareholding of the company. Average equity is the average of total owners equity at the beginning of the year and the end of the year.
Return On Equity = Net Income/Average Equity
Net Profit Margin
Profit margin is very important in any business. It tells us how much of a companies revenue (sales receipts) becomes profit. The more profit a company has, the more it can pay as a dividend or invest in other income-earning projects.
Net Profit Margin = Net Income/Sales Revenue
Liquidity ratios are concerned with a company’s ability to meet its obligations. The information is useful to investors of course but also creditors and lenders including debt holders.
This is a short term liquidity measure that looks at if a company can settle it’s short term obligations using only current assets held. Both Current Assets and Current Liabilities are found in the Balance Sheet.
Current Ratio = Current Assets /Current Liabilities
It would be ideal for the ratio to be greater than 1.
Also known as the acid test ratio looks at how prepared a company is to meet current obligations without disposing of inventory. This is done because in some cases inventory may take some time to sell and/or may have to be discounted to do so. Again this is useful to lenders, particularly trade creditors. Investors would be interested in this if a company has known liquidity problems.
Quick Ratio = (Current Assets – Inventory)/Current Liabilities
Debt ratios are all about assessing how much a company relies on debt. This is important because debt unlike equity has mandatory interest payments and is considered a more expensive source of finance.
Debt to Equity
The Debt to Equity ratio informs us of how much a company is leveraged, ie how much it relies on debt. All figures required for this are found in the balance sheet. As noted before the debt is considered an expensive source of finance.
Debt to Equity Ratio = Total Liabilities/Equity
While debt financing is considered expensive a low debt to equity ratio may show that management is not being adventurous enough. It is best compared with industry peers.
As mentioned earlier debt has mandatory interest payments and interest cover is a measure of how prepared a company is to meet its interest expense. As a rule of thumb higher is better but consider the point made about not being adventurous earlier on.
Interest Cover = Earnings Before Interest and Taxation/Interest Expense
Efficiency ratios are used to determine how well companies are converting assets into income. You can draw some parallels with profitability ratios. Because they look at the core business they are more industry-specific than profitability ratios.
Asset Turnover ratio
The asset turnover ratio discerns how well assets have been used to generate sales revenue. Notice how this differs from return on assets which looks at income the investor earns. This ratio is concerned with top-line business. The sales figure is in the income statement while average assets are in the balance sheets.
Asset Turnover Ratio = Sales/ Average Total Assets
The higher this number the better, however, you would want to compare this to industry peers.
Inventory Turnover Ratio
The inventory turnover ratio is concerned with how quickly a company moves inventory. An inventory cycle brings revenue to a company therefore the faster a company completes a cycle the better it performs.
Inventory Turnover Ratio = Cost Of Sales/Average Inventory.
Best practice in Financial Reporting is for companies to present some if not all of the above-mentioned ratios and comparative figure from the industry in the financial statements. It is dangerous to use one ratio in isolation to determine where a company stands, comparing the information is important.