Key Financial Ratios and Their Interpretation
Financial ratios help investors, analysts, and business owners assess a company’s financial health, profitability, and efficiency. Here’s a breakdown of some important financial ratios, their formulas, and what they indicate about a company’s performance.
1. Free Cash Flow (FCF) Yield
Formula:
FCF Yield = Free Cash Flow per Share / Market Price per Share × 100 or
FCF Yield = Free Cash Flow / Market Capitalization × 100
How to Calculate Each Term:
- Free Cash Flow (FCF) = Operating Cash Flow - Capital Expenditures (CapEx)
- Market Capitalization = Share Price × Total Shares Outstanding
Interpretation:
- High FCF Yield → The company generates strong cash flow relative to its stock price, often indicating an undervalued stock.
- Low FCF Yield → Weak cash flow compared to stock price, suggesting potential overvaluation.
2. Price-to-Earnings (P/E) Ratio
Formula:
P/E Ratio = Market Price per Share / Earnings per Share
How to Calculate Each Term:
- EPS = Net Profit / Total Shares Outstanding
Interpretation:
- High P/E → The stock is expensive relative to earnings, usually seen in high-growth companies.
- Low P/E → The stock is cheap relative to earnings, which could indicate an undervalued stock or weak growth potential.
Example: If a company's stock trades at ₹200 and EPS is ₹10, the P/E ratio is 20, meaning investors are willing to pay ₹20 for every ₹1 of earnings.
3. Dividend Yield Ratio
Formula:
Dividend Yield = Annual Dividend per Share / Market Price per Share × 100
How to Calculate Each Term:
- Annual Dividend per Share = Total Dividends Paid / Total Shares Outstanding
Interpretation:
- High Dividend Yield → The company returns a good portion of earnings to investors, making it attractive for income investors.
- Low Dividend Yield → The company reinvests profits into growth, common in high-growth stocks.
Example: If a company pays a ₹5 dividend per share and the stock price is ₹100, Dividend Yield = 5%.
4. Free Cash Flow (FCF) Margin
Formula:
FCF Margin = Free Cash Flow / Revenue × 100
How to Calculate Each Term:
- Revenue = Total Sales of the Company
Interpretation:
- High FCF Margin → Strong cash generation relative to revenue, indicating operational efficiency.
- Low FCF Margin → The company struggles to convert revenue into actual cash flow.
Example: If a company generates ₹50 Cr in FCF and has ₹500 Cr in revenue, FCF Margin = 10%, meaning 10% of revenue turns into free cash flow.
5. Gross Margin Ratio
Formula:
Gross Margin = (Revenue−Cost of Goods Sold ) / Revenue × 100
How to Calculate Each Term:
- COGS = Direct costs related to production (materials, labor, etc.)
Interpretation:
- High Gross Margin → The company retains more revenue after covering direct costs, meaning strong pricing power.
- Low Gross Margin → High production costs impact profitability.
Example: If revenue is ₹200 Cr and COGS is ₹120 Cr, Gross Margin = 40%, meaning 40% of revenue remains after direct costs.
6. Return on Invested Capital (ROIC)
Formula:
ROIC = Net Operating Profit After Tax (NOPAT) / Invested Capital × 100
How to Calculate Each Term:
- Invested Capital = Total Debt + Total Equity
- NOPAT = EBIT × (1 - Tax Rate)
Interpretation:
- High ROIC → The company efficiently generates profit from its capital.
- Low ROIC → Inefficient capital allocation.
Example: If NOPAT is ₹30 Cr and invested capital is ₹200 Cr, ROIC = 15%, meaning the company earns 15% on its capital.
7. Return on Equity (ROE)
Formula:
ROE = Net Income / Shareholder’s Equity × 100
How to Calculate Each Term:
- Shareholder’s Equity = Total Assets - Total Liabilities
Interpretation:
- High ROE → The company generates strong returns for shareholders.
- Low ROE → Weak profitability, possibly due to high debt.
Example: If net income is ₹40 Cr and equity is ₹200 Cr, ROE = 20%.
8. Capex to Cash Flow Ratio
Formula:
Capex to Cash Flow Ratio = Capital Expenditures (Capex) / Operating Cash Flow
Interpretation:
- High Ratio → The company invests heavily in growth but may have limited free cash.
- Low Ratio → The company has sufficient cash for other operations.
Example: If Capex is ₹30 Cr and Cash Flow is ₹100 Cr, Capex to Cash Flow Ratio = 30%.
9. Net Debt to Free Cash Flow Ratio
Formula:
Net Debt to Free Cash Flow Ratio = Net Debt / FCF
Interpretation:
- Low Ratio (<3) → The company can repay debt quickly.
- High Ratio (>5) → High debt burden, raising financial risk.
Example: If net debt is ₹200 Cr and FCF is ₹50 Cr, Net Debt/FCF = 4, meaning it would take 4 years of FCF to repay debt.
10. Debt-to-Equity (D/E) Ratio
Formula:
Debt/Equity = Total Debt / Shareholder’s Equity
Interpretation:
- High D/E Ratio (>1.5-2) → The company is highly leveraged.
- Low D/E Ratio (<1) → Financially stable, lower risk.
Example: If total debt is ₹300 Cr and equity is ₹200 Cr, D/E Ratio = 1.5, meaning moderate leverage.
Conclusion
Understanding these financial ratios helps investors make better decisions. While some ratios focus on profitability (ROE, ROIC), others assess risk (Debt/Equity, Net Debt/FCF) or cash flow strength (FCF Yield, Capex to Cash Flow).
