One of the most intriguing aspects of investing is investing in equities. Equities are high risk high reward vehicles of investments. Given their high risk nature one should scientifically approach this investment alternative. Equities can be dealt with directly i.e. investing directly in the stock market or through a mutual fund where experts manage our funds. A small amount of equity exposure is always good as it would help us understand how the market functions and leads us to wise decision making even while choosing a mutual fund.
Equity investment decisions need to be researched and thought through thoroughly to earn high rewards. We need to understand that analyzing investing in equity is analyzing a business which is a going concern. Over the lifetime of an organization, it will traverse through phases and will have different outlook towards business. All these need to be captured quantitatively in one form or another to reach a sound decision on investment.
Ratio analysis helps us in this area of equity research. Absolute numbers though important fail to provide a complete picture of an organization. For example, we can say that two competing firms A and B are profitable and have earned Rs. 50,000/- and Rs. 75,000/- as profit respectively but to get a clear idea about which firm is better we need to understand the amount they invested to earn the profits. This is exactly where ratio analysis helps us to understand things in a better fashion.
Ratio analysis can be defined as study of financial position of a company through various ratios derived from the financial statement s of the company.
Ratios are categorized into sections, these are
a) Liquidity Ratios
b) Activity Ratios
c) Debt Ratios
d) Profitability Ratios
e) Market Ratios
Liquidity ratios
Liquidity ratios inform us about the capacity of the company to service its debts with the assets that the company has at its disposal. Two of the most popular ratios in this category are current ratio and quick ratio.
Activity ratios
Activity ratio tells us about the firm’s ability to convert its non-cash assets into cash assets. This in turn means that this ratio tells how efficient an organization is, when it comes to managing its inventories. It’s a common knowledge that managing inventory efficiently is a hallmark of a good organization.
Debt ratios
Long term debts need to be secured. Ratios in this category are indicators of an organizations ability to service its long term debt. Debt ratios are also known as leverage ratios and these ratios tell us the extent of debt in an organizations capital structure.
Profitability ratios
An organizations aim is to generate profit for its investors. Profitability ratios are indicators of the efficiency of an organization in terms of using its assets to generate profit for the shareholders. These ratios tell us the trends of an organization like if a company is doing better than previous year, or is its profitability declining.
Market Ratios
A shareholder invests in an organization with a view of earning profit on the investment. These ratios are particularly helpful in analyzing if an organization has rewarded shareholders in terms of return on their investment in the organization. These ratios along with the profit ratios are important in analyzing an organizations ability to enrich its investors. Price to earnings ratio is a popular ratio which falls under this category.
Going ahead, we will see each of these ratio categories in detail.
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