Any financial professional would know that a company’s worth is based on its market value. Investors tend to value a company by examining its financial position based on the calculated ratios and financial statements. Therefore, to determine the market value of a company, the investors and shareholders must compare the company’s financial ratios with their competitors and industrial benchmarks. The financial analysis of a company is easy to perform. It is often a part of the program evaluation review technique (PERT). It is essentially a project management tool offering a graphical representation of the timeline of a given project. In this article, we will tell you how to check fundamental strength of any company.
Importance of ratio analysis
The term ‘ratio analysis’ is essential for a company to analyze its financial position, profitability, liquidity, solvency, risk, fund utilization, and operational effectiveness. In addition, it indicates the comparison of trends in a company’s financial results. This helps shareholders to make better decisions when investing in a company.
Listed below are some of the prime advantages of ratio analysis.
- Financial statement analysis
For internal and external shareholders, interpreting the financial data and statements is essential. For example, ratio analysis helps analyze numbers from income statements and balance sheets. In addition, it helps to summarize the growth of an organization’s earning power and dividend payments for equity investors.
- Operational efficiency of a firm
Ratios like inventory turnover ratio, account receivable ratio, and fixed asset turnover help to analyse the degree of efficiency within a firm. Such ratios measure a company’s ability to generate income with the help of assets. In addition, it looks after various aspects like the time taken by the firm to collect cash from debtors or the period for the same firm to convert the available inventory into cash.
- Understanding profitability of a company
Profitability ratios like return on assets and return on equity help to understand a firm’s ability to generate earnings. This ratio tells how well off is a company is using its investors’ money. Similarly, gross profit and net profit margin ratios help analyze a company’s ability to convert saves to profit.
- Identification of business risk
Ratio analysis is mainly used to detect any business risk within the firm. Through the calculation of leverages – financial and operating leverage, it helps a firm to understand the business risk. In other words, understand how sensitive a company’s profitability is with regards to its fixed cost deployment and the outstanding debt.
- Future planning and forecasting
Managers and analysts look into market trends and use them for forecasting, whereas the stakeholders use them for critical decision-making. It helps them to understand the best companies better to invest in.
- Performance comparison of firms
Understanding the strength and weaknesses of a firm is one of the primary uses of ratio analysis. It helps to compare a firm’s previous ratio with the current one. On its basis, progress analysis of a company can be made.
Most important financial ratios to analyze a company
When properly understood and applied, ratios help investors make more informed decisions when investing in a company.
Some of the significant ratios essential for any investor to know are:
- Working capital ratio
It defines a company’s capacity to pay its current liabilities with the help of available assets. In short, working capital serves as a measure of a company’s financial health, allowing creditors to measure a company’s ability to pay off debts within the stipulated period.
- Quick ratio
This ratio subtracts the inventories from the current assets. It is done before dividing the figure into liabilities. The idea is to showcase how the current liabilities are covered in cash and items with readymade cash value. This is because inventories take time to sell and convert into liquid assets.
- Price-earnings (P/E) ratio
This ratio tends to reflect the assessment of an investor’s future earnings. To obtain the ratio, investors determine a company’s stock and divide it by the EPS.
- Earnings per share
It is a measure of the company’s net income earned on each share of a firm’s common stock. When stakeholders buy stocks, they automatically take part in the company’s future earnings, including the risk of losses. However, a company with zero revenues will have zero or negative earnings per share.
- Debt-equity ratio
Suppose a prospective investment target tends to be too much. In that case, it will reduce the safety margins behind what one owes and jack up the fixed charges while reducing the available earnings on dividends, causing a financial crisis. This ratio is calculated by adding the outstanding short-term debt and dividing it by the equity book value of shareholders.
- Return on equity
A common thing that shareholders want to know is how profitable their capital is in the business they are investing in. This return on equity usually considers a firm’s net earnings while subtracting the preferred dividends. The resulting outcome is divided by the equity cash within the company.
The secret to winning the stock market with Eleanmarkets
Understanding the valuation analysis of stocks is essential to do well in the trading market. The course, ‘Secrets To Winning The Stock Market‘ is focused on simplifying the complex concepts within the stock market. It helps the investors better understand the company’s fundamental strength and avoid making costly mistakes in creating wealth in the long term.
Elearnmarkets and NSE Academy jointly offer the program to all aspiring investors and traders in the stock market. Some of the main objectives of this course are:
- Understanding the driving forces behind the stock price movements in the long run, usually three years or more.
- Learning to separate quality stocks from over 5000 companies.
- Learning all the important financial ratios mentioned above to easily understand the financial language.
- Getting to know the common mistakes the investors usually make to avoid them in the long run.
Areas covered within this program are understanding the ups and downs in stock price movements, the financial ratio for a quality selection of stocks, portfolio construction, cash flow analysis, valuation analysis, management analysis, and industrial analysis.
Bottom Line
A company’s financial position will tell an investor about its general well-being. Understanding a company’s financial statements and annual reports offers a general understanding and value of the company to be invested in. Learn and grow with Elearnmarkets and better understand the company’s financial statements and value.
