Written By: Milja Mieskolainen
Financial ratios are a good support when making investment decisions. They can tell the investor a lot about the current situation of the company: its earnings development, financial position, and market valuation. Other companies in the same industry can be used as a reference to get a concrete basis for the financial ratios. The key figures can vary greatly between industries, so attention should be paid to the benchmark. The investor should not rely on just one number but try to see the whole picture behind the set of numbers. A single number does not tell you whether a share is cheap or expensive or whether the company is in a good position. It is important to remember that investing is basically about looking to the future, which is worth keeping in mind when looking at the ratios.
This post goes through some of the financial ratios that are essential when making an investment decision. Some tips are listed at the bottom of the page if you want to learn more about the topic. The purpose of this blog post is to help you understand how the numbers are formed and what they mean.
Profitability: Profitability has long been considered a prerequisite for the company's operations. If profitability is weak, the company is not in a good position to continue operating. Poor profitability refers to a situation where a company makes a loss and eats up its equity.
Revenue-to-turnover ratios:
• Earnings Before Interest and Taxes (EBIT) = Indicates the amount of actual operating income remaining before financial items and taxes; write-offs and depreciation have been taken into account. Revenue + other operating income - operating expenses – write-offs and depreciation. (/ turnover * 100%)
• Net income = Generally considered as a result of actual operations, serves as a basis for several profit distribution decisions. Operating profit +/- financial items +/- taxes. (/ turnover * 100%)
• Earnings Before Interest, Taxes and Amortization (EBITA) = Indicates how much of the company's net sales is left when operating expenses are deducted. Operating profit + write-offs and depreciation. (/ turnover * 100%)
• Total result = Describes the total result for the financial year, including extraordinary and non-recurring income and expense items. Net result +/- incidental items. (/ turnover * 100%)
Return on equity ratios:
• Return On Equity (ROE) = Indicates how much return the company generates on capital, i.e. describes the ability to take care of the capital invested in the company by the owners. Equity should be calculated as an average of, for example, the values at the end and beginning of the financial year. 100 * net profit (12 months) / Adjusted equity on average.
• Return On Investment (ROI) = Measures the relative profitability of a company. Invested capital is calculated as the sum of equity and interest-bearing liabilities. 100 * [net profit + financial expenses + taxes (12 months)] / average invested capital.
• Return On Assets (ROA) = Indicates how much capital committed to the company generates taking into account debt as well. The result before financial expenses and taxes is compared with the capital committed to business operations. 100 * [net result + financial expenses + taxes (12 months)] / Adjusted balance sheet total on average.
Solvency & liquidity: In addition to profitability, the company's financial structure must be on a solid footing so that the running costs of the business do not become a problem. Solvency measures a company's ability to meet its financial obligations in relation to profitability. Liquidity looks at ongoing expenditures, such as purchases of goods, and managing them.
Financing structure:
• Equity ratio = Measures a company's solvency, ability to meet its commitments in the long run and loss tolerance. Indicates how much of a company’s assets are financed with equity, a high figure indicates stability. Equity / balance sheet total (* 100%).
• Net gearing = Describes a company's indebtedness and measures the company's interest-bearing net debt to equity ratio. (Interest-bearing liabilities - liquid assets) / equity (* 100%).
• Relative indebtedness = Measures the ratio of a company's debt to the size of its operations. The company's total liabilities are related to turnover. Adjusted balance sheet liabilities / turnover (12 months) (* 100%).
Adequacy of financing:
• Net financing expense, financing burden = Indicates the share of current financial expenses in net sales. The higher the number, the higher the company's gross margin requirements. Net financing expenses / turnover (* 100%)
• Net financing expenses / gross margin = Measures the share of financial expenses in gross margin, i.e. the proportion of gross margin attributable to debt financiers as current financial expenses. Net financing expenses / gross margin (* 100%).
Balance sheet ratios (liquidity):
• Quick ratio (acid test) = Measures a company's ability to meet its short-term debts with its quick cash assets. The recommended value is 1, in which case the company's financial assets cover the amount of current liabilities. (Current receivables + cash and bank receivables + financial securities) / (current liabilities - current prepayments received)
• Current ratio = Measures the company's financial buffer at the balance sheet date. (inventories + current receivables + cash and bank receivables + financial assets) / current liabilities.
Valuation ratios (stock exchange):
Valuation ratios describe the ratio of the market value of listed companies to the financial statements. They allow the investor to view stock pricing on the stock exchange and compare it with, for example, future prospects.
Development of the P / E ratio of companies on the Helsinki Stock Exchange 2012-2016, median. Source: Alma Talent
• Market value = Describes the total market capitalization of a listed company. Total number of shares * share price.
• P/E = Indicates how many years a company would make a profit equal to its market value if the result remained the same, i.e. how many times the profit level corresponds to the market value. A low P/E ratio is generally considered to be one definition of a value stock. At company level: market value / (net profit - minority interest in profit or loss). At the share level: Share price / earnings per share.
• P/B = Describes the ratio of the share price to the equity per share, i.e. how many times the market value is in relation to the equity according to the balance sheet. At company level: market value / equity without minority interest. At the share level: share price / equity per share.
• P/S = Measures how much a company makes in relation to its market value, i.e. how many times the market value is in relation to its annual turnover. Market value / turnover.
• EV/EBITDA = Describes the ratio of the company's debt-free market value, i.e. also takes into account existing debt and liquid assets. Market value / gross margin.
• EV/EBIT = Describes the ratio of a company's debt-free market value to operating profit. Depreciation of assets is taken into account by excluding depreciation and write-offs. Market value / operating profit.
• Dividend yield -% = Describes the ratio of the dividend to the stock exchange price in percent, i.e. tells the investor the amount of the dividend in relation to the value of the investment. Dividend per share / share price * 100%.
More information on the topic: (Some are in Finnish)
Podcasts: Available on Apple Podcasts and Spotify
Basics: Key Metrics for Different Investing Styles / Equity Mates Investing Podcast
Mistä tunnistaa menestyvät ja menehtyvät yritykset? / Jargonmankeli
Other:
Inderes’ Blog: Mikä on P/B -luku? + Tunnusluvuista ja niiden laskennasta