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Having gone through the Beginners’ Guide to Financial Statements, are you now wondering what is the next step?
With the introduction to financial ratios, this will help you in further analysing the financial statements, regardless of your objective!
Return on Assets (ROA)
Return on Assets = Net Profit / Total Assets
A higher ROA would mean that the company is better at utilising its investment in assets to generate profits.
Return on Equity (ROE)
Return on Equity = Net Profit / Total Equity
The ROE ratio shows how efficient the company is utilising its equity to generate profits.
The difference between the ROA and ROE ratio is that the ROA takes into account both debt and equity, while ROE, like its name suggests, only takes into account the equity portion.
Return on Investment (ROI)
ROI = Net Operating Profit After Tax* / Invested Capital
*Operating profit can also be referred to Earnings Before Interest and Tax (EBIT)
This ratio considers only profits generated from the core business operations, which is why it takes net operating profit over net profit. If the ROI of a company is higher than its Weighted Average Cost of Capital (WACC), this would mean that the company is generating more returns than costs. In essence, the WACC is the cost that the company is paying for their capital (which may be borrowed).
Dividend Ratios
Dividend Yield = Dividend / Share Price
If you are keen on dividends, this is the ratio you should definitely look out for! However, it is important to understand the underlying factors as well – are the dividends increasing, is the ratio only increasing because share price is falling?
Dividend Payout Ratio = Total Dividends Paid Out / Net Profit
A higher dividend payout ratio may not necessarily always be a good thing. In the long-run, this would mean that the company doesn’t retain money to plowback into their business in order to grow.
It is definitely important to note that having a higher dividend now may not always be the best case scenario for both investors and owners.
Summary
Now that you know how to calculate a few basic equations, do try it out, and see what insights you can gain out of the company’s financial statements.
