True Investing’s Guide

Ratio Analysis
10 Ratios to Analyze Business Quality,
Financial Strength and Valuation of
Companies.
 True Investing’s Guide
Ratio Analysis
10 Ratios to Analyze Business Quality,
Financial Strength and Valuation of
Companies.
 PREFACE
Hello True Investor!

Welcome to the thrilling world of ratio analysis! Finance isn't just

about numbers and graphs - it's an adventure filled with discoveries.
In this book, "Guide To Ratio Analysis," ratios become your detective's
magnifying glass into the heart of a business.

Think of ratio analysis as the company's DNA, showing you its

strengths, weaknesses, and everything in between. This eBook
empowers you to decode this DNA and make smarter investing
decisions.

Our guide is divided into three parts: 'Business Strength,' 'Financial

Strength,' and 'Valuation.' We'll peek into the operational metrics to
gauge a company's business strength, scrutinize its financial health
to assess its ability to weather storms, and explore valuation to
determine if a stock is a hidden gem or a costly mistake. Each section
is vital in identifying strong investment opportunities.

Worried ratio analysis sounds complicated? Fear not! We've

translated complex financial jargon into simple, relatable language.
This book is your friend, mentor, and guide, whether you're a college
student, a young professional, or a curious learner.

Investing isn't just about money, it's about freedom - the freedom to
make choices, to chase your passions, to live life on your terms. This
book isn't just about ratio analysis; it's about sparking a desire within
you to take control of your financial future.

Happy Investing!
 Table of Contents
Why is Stock Analysis Important?...............................................1

What is Business Quality?............................................................3

Ratios to Analyze Business Quality..............................................4

Return on Equity (ROE).................................................................5

Return on Capital Employed (ROCE)............................................6

Gross Margin (GM).........................................................................7

Net Profit Margin (NPM)................................................................8

What is Financial Strength?.........................................................9

Ratios to Analyze Financial Strength.........................................10

Debt to Equity Ratio (D/E Ratio)..................................................11

Interest Coverage Ratio (ICR)......................................................12

Current Ratio (CR)........................................................................13

What is Valuation?......................................................................14

Ratios to Analyze Valuation........................................................15

Price to Earnings Ratio (PE Ratio)...............................................16

Price Earnings to Growth Ratio (PEG Ratio)...............................17

Price to Book Ratio (PB Ratio)......................................................18

Conclusion...................................................................................19
Why is stock analysis important?

There are more than seven thousand companies listed in the Indian
stock market and almost all of the successful Indian investors tell
that only about five hundred of them are worthy of investing, i.e., less
than 10%. So, what are the chances that the company we are going to
invest in is a good company? To be honest, very very low.

In the stock market, big money is made when we invest in a good

company at a reasonable price which continues to grow its revenue
and profits year after year for a very long time. Hence, our real work in
the stock market is to find such companies which are good and
reasonably priced among the many which are just plain bad or
overvalued. Stock analysis is the tool which helps us in this work.

Analyzing a stock is no easy work, but with the help of different kinds

1
of financial ratios we can eliminate bad companies very fast, which
can greatly increase our chances of investing in a good company.

So, here, we will know about ten financial ratios which tell different
things about companies and by seeing these ratios we can know a lot
about the company.

We will use these financial ratios to analyze three things about a

company, business quality, financial strength, and valuation.

Let’s get started.

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2
1. Business Quality

What is Business Quality?

A high-quality business is one which has been consistently increasing
its revenue and profits for many years and there is a very high chance
that it will continue to do so for many years to come.

Business quality mainly comes from a company's ability to sell its

products and services at a higher margin to more customers than its
competitors. This happens either because the company’s products
and services have very high customer demand due to brand
recognition or the company can manufacture its products or services
at a lower price than its competitors.

3
 Ratios to analyze
Business Quality

4
Ratio #1

Return on Equity (ROE)

It is a profitability ratio which tells how much profit a company is
making on its shareholders equity in a given time.

Shareholders
Equity

ROE = Net Profit / Total Shareholders Equity

We get net profit from the company's income statement and total
shareholders’ equity from the company's balance sheet.

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Statements

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For a company, ROE greater than 15% every year from the last 3 to 5
years signifies that the company is very strong in its business.

If the ROE of a company is less than 15% for several years, most
probably it’s not a strong player in its industry, and we should move to
analyze another company.

So, ROE should be greater than 15%.

5
Ratio #2

Return on Capital Employed (ROCE)

It is also a profitability ratio which tells how much profit a company is
making on its total capital employed in a given time.

Total
Capital Employed

Earnings Before Interest & Taxes (EBIT)

ROCE =
Total Assets – Current Liabilities

We get EBIT from the company's income statement, which is the

company's profit including all expenses except interest and tax
expenses, and we get both total assets and current liabilities from the
company's balance sheet.

For a good company, ROCE should also be more than 15% every year
from the last 3 to 5 years. And we should avoid companies whose
ROCE is less than 15% for several years.

So, ROCE should be greater than 15%.

6
Ratio #3

Gross Margin (GM)

It is a profitability ratio which tells how much money a company is
making after subtracting the direct cost it incurs to manufacture its
products or provide services from the revenue generated by selling
those goods and services.

For example, if a company incurs a cost of 20 rupees to manufacture a

product and it sells the product at a price of 50 rupees, then the
company has a gross margin of 60%, as it makes a gross profit of 30
rupees on the sale price of 50 rupees after subtracting the direct
manufacturing cost of 20 rupees. And, 30 rupees is 60% of 50 rupees.

Total Revenue – Cost of Goods Sold (COGS)

Gross Margin =
Total Sales

We get both total revenue and cost of goods sold from the company's
income statement. Point to note is that Cost of Goods Sold is
sometimes also called Cost of Sales and Cost of Materials Consumed.

A consistent gross profit margin of more than 50% every year for the
last 3 to 5 years is considered very good.

If we are comparing companies in one industry, then the companies

consistently having the highest gross margin ratios should be
analyzed in detail as such companies may have some kind of pricing
power, and such companies are more likely to be a good investment in
the long term.

So, Gross Margin Ratio should be greater than 50%.

7
Ratio #4

Net Profit Margin (NPM)

It is also a profitability ratio which tells how much net profit a
company is making on its total sales.

For example, if a company is making a net profit margin of 5% then it

means that for sales of every 100 rupees, it makes 5 rupees of net
profit.

Net Profit
Total Sales

ROE = Net Profit / Total Shareholders Equity

We get both net profit and total shareholders equity from the
company’s income statement.

For a company, the higher the net profit margin, the better it is. But, a
consistent net profit margin of more than 15% every year for the last
3 to 5 years is considered very good. If we find a company which has a
net profit margin of more than 15% consistently for several years
then we should analyze the company in more detail by checking more
financial ratios of the company.

So, Net Profit Margin should be greater than 15%.

8
2. Financial Strength

What is Financial Strength?

Financial strength primarily means having a very strong balance
sheet. If a company can keep on growing its revenue and profits at a
good rate by using its own cash and without taking any debt, then the
company is considered financially strong.

The major reason a company becomes financially weak is by taking

debt. Many great investors say that debt is the number one killer of a
business. This means that we should be very cautious while investing
in a company which has debt. The best strategy is to just stay away
from such companies.

9
 Ratios to analyze
Financial Strength

10
Ratio #5

Debt to Equity Ratio (D/E Ratio)

It is a solvency ratio which tells how much debt a company has taken
on 1 rupee of shareholders equity.

For example, if a company has a debt-to-equity ratio of 3, it means that

for every 1 rupee of shareholders equity, the company has taken a
debt of 3 rupees.

1 Rs of
Shareholders
Equity

D/E Ratio = Total Liabilities / Total Shareholders Equity

We get both total liabilities and total shareholders equity from the
company's balance sheet. Debt makes companies financially weak as
companies have to pay regular interest on it. Due to this, investors
generally prefer companies which have no debt or very low debt.
Hence, they like to see debt-to-equity ratio of less than 1, lesser the
better. For financial companies, like banks and NBFCs, the
debt-to-equity ratio can be more than 6 or 7 as their business is
dependent on taking debt and then lending it to people. This is why
we should not compare debt-to-equity ratio of financial companies
with the companies of other industries.

So, Debt to Equity ratio should be less than 1.

11
Ratio #6

Interest Coverage Ratio (ICR)

It is also a solvency ratio which tells the interest paying capacity of a
company.

Interest
Paying Capacity

Earnings Before Interest & Taxes (EBIT)

ICR =
Total Interest Expense

We get both EBIT and Total Interest Expense from the company's
income statement.

If a company has an Interest Coverage Ratio of 10, then it means that

the company’s profit before paying any interest and taxes is 10 times
its interest expense.

High Interest Coverage Ratio for a company signifies that the

company makes enough profit to pay its interest expense easily.

Investors like to see Interest Coverage Ratio of at least 3, the higher the
better. And if a company’s Interest Coverage Ratio is less than 3, it is
considered as financially risky.

So, Interest Coverage Ratio should be greater than 3.

12
Ratio #7

Current Ratio (CR)

It is a liquidity ratio which tells the ability of a company to pay its
short-term liabilities, i.e., which are due within a year.

Short-term
Liabilities

Current Ratio = Current Assets / Current Liabilities

We get both current assets and current liabilities from the company's
balance sheet.

Investors like to see a current ratio between 1.5 to 3. A current ratio

less than 1 is considered very risky as it may put the company in
financial trouble.

But, an excessively high current ratio is also considered bad, as it

means that the company is not using its current assets effectively.
Investors generally are concerned when a company has a current
ratio of more than 3.

So, Current Ratio should be between 1.5 and 3.

13
3. Valuation

What is Valuation?
Valuation is a method to find out if a company is overvalued or
undervalued compared to other companies or from its own historical
valuation.

Father of investing, Benjamin Graham wrote in 1934 that every

company has a certain value which is different from its share price.
And, it happens all the time that a company’s share price can become
less or more than its actual value. And he said that, we should buy
shares in a company when its share price is less than its actual value
i.e., when it is undervalued, and sell its shares when its share price is
more than its actual value i.e., when it is overvalued.

Investing success does not only depend on investing in good

companies, but on investing in them at the time when they are
undervalued. Share price of companies moves in cycles of
overvaluation to undervaluation to overvaluation again, and our
returns are significantly affected by the fact that, when in this cycle
we have invested in the company.

So, it’s always better to check valuation of companies in whatever

ways possible to make sure we aren’t investing in an overvalued
company.

14
Ratios to analyze
Valuation

15
Ratio #8

Price to Earnings Ratio (PE Ratio)

It is a valuation ratio which tells how much price investors are
currently willing to pay for 1 rupee of profit made by the company.

For example, if a company has a PE ratio of 20, then it means that

investors are currently paying 20 rupees for 1 rupee of profit made by
the company.

Profit

PE Ratio = Current Share Price / Earnings Per Share

We get the current share price from the stock market and earnings
per share from the company's income statement.

Value investors generally like to invest in companies which have a low

PE ratio as it represents undervaluation while they do not invest in
companies having a very high PE ratio as it is considered overvalued.
Generally, PE ratio less than 15 is considered low, between 15 to 30 is
considered normal and above 30, it is considered as overvalued. If a
company’s PE ratio is less than its historical PE ratio, then it is
considered as undervalued and if its PE ratio is more than its
historical PE ratio, it is considered to be overvalued.

So, the PE ratio should be less than 15 and less than the company's
historical PE ratio.

16
Ratio #9

Price Earnings to Growth Ratio (PEG Ratio)

It’s a valuation ratio popularized by legendary American investor
Peter Lynch. It tells that a company is overvalued or undervalued
relative to its earnings growth.

Peter Lynch said that along with PE ratio, using PEG ratio will give us
more clarity about the valuation of a company.

Overvalued?
Undervalued?
Earnings Growth

PEG Ratio = PE Ratio / Earnings Growth

We already saw how to calculate PE ratio and to get earnings growth

for a fixed period we measure the compounded growth of earnings
per share of the company.

PEG Ratio less than 1 is considered as undervalued and above 1 is

considered as overvalued. Successful Indian investor Raamdeo
Agarwal also advises to use PEG ratio while valuing a company.

So, PEG Ratio should be less than 1.

17
Ratio #10

Price to Book Ratio (P/B Ratio)

It is also a valuation ratio which tells how much price we are paying
for 1 rupee of book value of a company.

For example, if a company has a price to book ratio of 5, it means that

we are paying 5 rupees for 1 rupee of book value of the company.

Book Value

P/B Ratio = Current Share Price / Book Value Per Share

We get share price from the stock market and book value per share by
calculating book value first by subtracting total assets from total
liabilities and then dividing it by the total number of shares of the
company.

Generally, a price to book ratio of less than 1 is considered as

undervalued, between 1 to 3 is considered normal and a price to book
ratio above 3 is considered as overvalued.

Price to book ratio is most relevant for financial companies. For

companies which are asset light, such as IT companies and internet
based companies, price to book ratio ratio means very less.

So, the Price to Book Ratio should be less than 1.

18
Conclusion

19
We saw ten financial ratios which tell about business quality,
financial strength and valuation of companies, and we learnt how to
compute them, and what they mean for a company.

But we do not necessarily have to calculate these ratios ourselves.

There are many websites where we can easily get all of these ratios
for every company. Websites like screener.in, tijorifinance.com and
tickertape.in are good places to check these ratios.

But, it often happens that these platforms provide different data for
the same companies. And, that’s why, the best option is to look into
companies' financial statements from where these ratios come from.

There are three main financial statements, the balance sheet, the
income statement and the cash flow statement.

We have prepared eBooks on all these financial statements in very

simple language which you should read. You can check these eBooks
in our app.

Additionally, there are a few things we should keep in mind while

analyzing these ratios, which are as follows.

We should not invest in a company just by seeing one or two ratios

but try to analyze more and more ratios for every company to get
the whole picture of the company.

We should also not invest in a company by just seeing ratios for one
or two years. It may happen that the company has made a large
profit in one or two years and due to this, its ratios appear to be
excellent. So, we should look for all the ratios for the last 3 to 5 years
and also check the average of these ratios for the last 3 to 5 years to
see if the company is really good or it just made some one-time
profits.

20
 Investing success does not only depend on buying good companies,
but on buying good companies when they are undervalued. So, we
should not just invest in a good company we just found, but we
should also see if it’s undervalued or not.

We should remember that there are millions of people in the stock

market and most of the people do not bother to do even a basic
analysis of companies before investing in them. So, if we do stock
analysis before investing in companies, we will be far ahead from
such people, and our chances of success in investing will increase.

And lastly, we should understand this very important point that

there is absolutely no compulsion for us to invest in any given
company. We can and should keep on passing on companies until
we find a company that fits all our conditions. Most people overlook
this simple fact and invest in the companies everybody is talking
about, which is the easiest way to make losses.

Concluding the conclusions, we would like to say that investing is an

individual endeavor, and, the more independent decisions we will
make after careful study and analysis, chances of our success will
increase.

Best wishes for your investing success and see you next time.

Until then, take care,

True Investing Team

21
Business Quality Financial Strength Valuation

ROE > 15% D/E Ratio < 1 PE Ratio < 15

ROCE > 15% Interest Coverage > 3 PEG Ratio < 1
Gross Profit Margin > 50% Current Ratio > 1.5 but < 3 P/B Ratio < 1
Net Profit Margin >15%

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26