Balance Sheet Counting: An Analysis of Financial Ratios Used by a Financial Analyst

Ratio analysis is a quantitative method of analyzing information recorded in a company’s financial statements. The information used for analysis include those on the balance sheet, income statement, and cash flow where the ratio of one item or combination in relation to the other is calculated. The financial analysts aim at evaluating the operation and performance of a company regarding efficiency, liquidity, solvency, and profitability. The calculated ratios are monitored, and trends studied to determine if the ratios are improving or deteriorating.

Moreover, different companies are compared within the same sectors to find out the variations among them. Therefore, the ratio analysis forms the main pillar of company analysis (Babalola and Abiola, 2013).

Price/Earnings Ratio

According to Phan et al. (2015) price/earnings ratio refers to the ratio of a company stock to the company earnings per share. They are used to tell the value of a company, give an idea of the markets willingness to pay for a company earning, and the stock’s value in the market.

Price/earnings ratio is used by investors to decide whether to invest in a company or not. To find the ratio, the investors or analysts use market value per share to estimate the earnings per share. Different types of price/earnings ratio are dependent on the types of earnings and whether they are projected or realized. When the price/earnings ratio of the previous quarters are calculated, then it is referred to as trailing price/earnings ratio. On the other hand, price/earnings ratio calculated using estimates of net earnings of the subsequent quarters are called future price/earnings.

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High price/earnings ratio is an indication that a company is expected to grow and the investors are likely to reap from their capital investments. A lower ratio is an indication of a slow growth of a firm. However, lower ratios do not mean that the company has failed, but it may be an indication that the firm has a solid market share. The price/earnings ratio also helps in evaluating the market as a whole. This is possible when the existing companies in the market are evaluated over the same time, and this is important for investors (Phan et al., 2015).

Gross Dividend Yield

The dividend vield is a financial ratio that is used to determine the amount that a company get as dividends each year relative to the company’s share price. The dividend yield is calculated by dividing the dividend of each share by the price of each share in the market. The dividend yield is expressed as a percentage, and thus the result of the division is multiplied by 100 percent. The gross dividend yield is the dividend yield in which the taxes have not been deducted, and thus the calculation of the gross dividend is done using the gross dividend per share. According to Fong and Ong (2016), gross dividend yield measures the productivity of an investment. Investors can grab promising opportunities and invest in companies that can give returns on investments. The investors compute the cash flow that they will get from their investments. Through computation, a company with a high gross dividend yield is likely to pay investors large dividends as compared to the market value of the stock. Thus, before investing in a firm, investors need to calculate the dividend yield ratio of a company. Profitable companies pay good dividends. The formula for calculating the Gross dividend yield is: (Gross dividend yield per share/ (Market price per share) ×100

Coverage Ratio

This is the measure of the ability of a company to meet its financial obligations. The coverage ratio gives an insight of a company’s financial health and position (Kim et al., 2013). The coverage ratio is important to the investors and the company itself since it informs them whether to invest or not. The inability of a company to repay for its liabilities makes the company sells its assets and thus may be declared bankrupt. When a company is declared bankrupt, the investors are unlikely to get returns on their investment, and thus new investors would shy off from such firms.

Kim et al. (2013) argued that coverage ratio is utilized by different stakeholders or investors who are interested in a firm. Based on the institution calculating the coverage ratio, there are different types of coverage ratios. Debt service coverage ratio is calculated by a financial institution to understand the cash profit availability of a company and thus determine if the firm can repay the debt including the interest. Essentially, this is calculated when a firm takes a loan from a financial institution or any loan provider. This ratio is important to the lender as it enables it to determine the ability of the entity to repay loans. Interest service coverage ratio is another type of coverage ratio used by lenders to gauge the capability of a firm to repay interests on loans. A coverage ration less than 1 suggests that the profits generated by the firm are not enough to repay the interests on loans. Dividend coverage ratio is another important type of coverage ratio used by equity stakeholders to determine if an investment in a firm would result in good dividend yields.

Grinblatt and Titman (2016) postulated that coverage ratio helps in the determination of financial positions of a company. Through the coverage ratio, the potentially troubled firms can be identified. Investments on them may be too risky for an investor or a lender and thus they avoid them once they identify the risky ones. Lower ratios are an indication of danger since the company is at its edge of falling. A deep dive into the company financial statements are important in the determination coverage ratio. The financial statements used include net income, outstanding debts, and interest expense.

Earnings Per Share Ratio

This a company’s profit allocated to each share of common stock. It indicates the profitability of a company. Earnings per share ratio is an important tool for investors and stock market traders. Higher earnings per share in a company is an indication of profits, and thus more investors are likely to join the company. The earnings per share are calculated by taking the company profit and dividing it by the number of outstanding shares (Almeida et al., 2016).

Conclusion

Financial ratios are used to express the relationship between different financial statement items. The ratios give the historical data, strengths, and weaknesses, and estimate the future performance of a company. The ratios are used to calculate the liquidity, solvency, profitability, and efficiency of a company. The ratios thus help investors, lenders and financial institutions to compare the performance of various companies in the same sectors.