Benefits and limitations of investment ratios

One of the tools that stockbrokers deploy to ascertain the financial health of a company before executing client’s purchase or sale order is investment ratio. There are many investment ratios, depending on the objective of the user. This is a risk aversion strategy.

Securities dealers cannot conduct proper analysis without the application of these tools called financial ratios. The ratios are contained in the company’s financial statement which comprises basic information that appeal to diverse users for different reasons.

Users of financial statement are the company’s management, government and its agencies, banks and other financial institutions, customers, competitors, investment analysts and employees.

Each user needs financial statement to achieve different objectives. Financial ratios are numerous. Our focus here is the frequently used investment ratios. Some of the top ratios are Profit Margin, Price-to-Book Ratio, Earnings Per Share {EPS}, Price-To—Earnings Ratio {P/E}, Dividend Yield, Debt-to-Equity Ratio {D/E Ratio), Return On Equity (ROE) and Current Ratio

Profit Margin: The ratio shows how a company’s profit compares to its revenue. It is expressed in percentage. There are two types of Profit Margin: Gross Profit Margin and Operating

Profit Margin. The Gross Profit Margin uses revenue minus cost of revenue while the Operating Profit Margin uses the gross profit minus overhead items. A higher profit margin is indicative of a better way the company spends its income. But this ratio differs from one sector to the other.

Formula for profit margin: Net Profit /Revenue

Price-To-Book Ratio: This is also known as market-to-Book Ratio. The ratio compares a company’s current market price to its book value. The book value is the value of an asset in the company’s financial statement. Calculating this ratio at times may reveal investments that the market has overlooked but has a great potential.

A ratio is less than one means the current market price is lower than the book value. It may suggest market negative reaction to poor performance of a company.

Formula for P/B Ratio: Market capitalization/book value

Earnings Per Share: This ratio simply shows the net income that a company’s ordinary share also called equity or common stock has generated over the past one year. Preference shares also called preferred shares are not common stock and therefore not included in the calculation of EPS. It must be noted that common stock may change at any given period, but the company must disclose the current one.

Formula for EPS: Net income/ average outstanding shares

Price-to-Earnings Ratio {P/E}: This ratio reveals the relationship between the price of a stock and its earnings. It answers the question of how much will the market pay for the company’s earning? It shows expensiveness or cheapness of a stock.

Formula for P/E Ratio: Price per share /earnings per share

Dividend Yield: The ratio measures the quantum of the company’s profit distributed as dividend. One of the major ways that a company reward investor is by paying dividend regularly. For instance, if a company pays a dividend of N2 per share, a shareholder who owes1000 units of shares will be credited N2000 in his account. But this is subject to withholding tax. Dividend yield is expressed is expressed as an annual percentage.

Formula for dividend yield: Dividend per share/ price per share

Debt-to-Equity Ratio: This shows the relationship between a company’s total debt and net worth which is called shareholder equity. The ratio will indicate the extent to which the company is in debt and therefore the percentage of its leverage. If the ratio of debt is higher than equity, the company is said to be high-geared. This may be a symptom for technical insolvency or gradual movement toward liquidation.

Formula for D/E Ratio: Total debt/total shareholder equity

Return On Equity {ROE}: The ratio measures the level of efficiency of a company in making profit. This depends on how the company utilizes the invested funds. If a company generates N5 million in 2019 and has N7 million in shareholder equity, the result is 0,7 {5/7}. This is 70 percent ROE. The higher the percentage, the better. But the ratio is only used for a company that produces profit.

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Formula for ROE: Net profit/average shareholder fund

Current Ratio: This shows liquidity of a company in meeting its current financial obligations. The company’s ability to achieve this largely depends on the ratio of its current assets to current liabilities. For instance, if a company’s total current assets amount N10 million and liabilities, N2 million, its current ratio is 5 ie ((10/2) A current ratio of above one implies that the company highly liquid as its current assets can pay off its debts while a Current Ratio of below one is an indication of technical insolvency.

Formula for current ratio: Total current assets/ total current liabilities

Drawbacks of ratio analysis

At the basic level, ratio analysis is not without a number of drawbacks. Uncertainty of future may render ratio analysis irrelevant. There are variations in accounting methods while incorrect accounting data may distort ratio analysis and this can lead false reports.

There are situations when changes occur in price levels and this may lead to inaccurate analysis. No particular method of ratio analysis that is fool proof since there is no common standard. Different meanings are assigned to the same thing in ratio analysis. The analysis ignores qualitative factors among others.