Why do stock investors calculate financial ratios before investing into a stock?
This is because they want to find out the financial health of a stock first prior to investing into it. This is determined by calculating financial ratios of a stock. The concept is similar to how medical practitioners calculate a series of ratios which include blood pressure, BMI, body-fat… etc to determine our level of health. If a stock has good financial health, investors may invest if its stock price is cheap. If not, investors may choose to discard it as a potential candidate for investment.
Let’s use Sheng Siong Group Ltd as an example. What would savvy investors like to find out about its financial health? Here, I’ll list down 8 key financial ratios to know to effectively assess the financial health of the company.
Ratio #1: Net Profit Margin (NPM)
NPM tells us how much profits Sheng Siong makes from every S$ 100 it brought in in sales. It is computed by the formula below:
NPM = (Profits After Tax / Revenue) x 100%
Both profits after tax and revenue figures are obtained at its income statement. In 2019, Sheng Siong generated S$ 991.284 million in revenue and has made S$ 75.755 million in profits after tax (PAT). Thus, its NPM is 7.64% in 2019. In other words, from every S$ 100 in revenue, Sheng Siong made S$ 7.64 in PAT in 2019.
= (Profits After Tax / Revenue) x 100%
= (S$ 75.755 million / S$ 991.284 million) x 100%
Ratio #2: Return on Equity (ROE)
ROE tells us how efficient a company is in using shareholders’ equity (capital) to generate shareholders’ earnings (earnings). It is calculated as follows:
ROE = (Shareholders’ Earnings / Shareholders’ Equity) x 100%
Shareholders’ earnings (earnings) of a stock is recorded in its income statement while shareholders’ equity (capita) is recorded in its balance sheet. In 2019, the company has recorded S$ 75.732 million in shareholders’ earnings (this profit is one that belongs to shareholders as it is calculated by excluding PAT from profit owned by non-controlling interest). Also, Sheng Siong has S$ 313.251 million in shareholders’ equity. Thus, its ROE is 24.18%.
It means Sheng Siong made S$ 24.18 in shareholders’ earnings from using each S$ 100.00 it has in shareholders’ equity.
= (Shareholders’ Earnings / Shareholders’ Equity) x 100%
= (S$ 75.732 million / S$ 313.251 million) x 100%
Ratio #3: Current Ratio
Current ratio tells us if a stock has the means to pay its bills and has excess cash or financial resources in hand to invest for the future. This is important as savvy investors want to know if the stock can continue to pay dividends or to reinvest its financial resources for future growth, a key to sustainable capital growth. It is calculated with the formula below:
Current Ratio = Current Asset / Current Liabilities
Both current assets and current liabilities can be obtained in its balance sheet. I found that in 2019, Sheng Siong has S$ 176.566 million in current assets and it has S$ 184.114 million in current liabilities. Thus, its current ratio is 0.96, which means, it has financial resources to cover 0.96 years (11.5 months) of expenses presently.
Current Ratio 2019:
= (Current Assets / Current Liabilities)
= (S$ 176.566 million / S$ 184.114 million)
= 0.96 years or 11.5 months
Ratio #4: Gearing Ratio
Gearing ratio tells us how reliant a company is in using debt to fund its business operations. One of the ways to calculate a company’s gearing ratio is as follows:
Gearing Ratio = (Interest-Bearing Debt / Shareholders’ Equity) x 100%
Interest-Bearing Debt can be found in both non-current and current liabilities in a company’s balance sheet. Shareholders’ equity is also obtained in its balance sheet. In 2019, Sheng Siong has no interest-bearing debt and has as much as S$ 313.251 million in shareholders’ equity. Thus, its gearing ratio is 0% and shows that Sheng Siong is not reliant on debt to finance its assets / business operations.
Gearing Ratio 2019:
= (Interest-Bearing Debt / Shareholders’ Equity) x 100%
= (S$ 0 / S$ 313.251 million) x 100%
Ratio #5: Debtor Days
Debtor Days tells us how fast a stock is in collecting cash after selling and billing its customers for its products and services.
For instance, if you buy a Coke from a Sheng Siong store, you have to pay first before consuming it. This is known as cash sales (no debtor days). But, if you’re a freelancer who allows your customer to settle payment in 60 days after work is done, if the customer paid you on the 60th day, then, your debtor days is 60 days as it took you 60 days to collect payment from your customer. So, how to calculate debtor days of a company? Here’s the formula below:
Debtor Days = Trade Receivables / Revenue x 365 days
Trade receivables can be obtained at current assets in a balance sheet. Revenue figure is easily found in the company’s income statement. In 2019, Sheng Siong has S$ 17.981 million in trade receivables and has generated S$ 991.284 million in revenue. As such, its debtor days are 6.6 days. It means, Sheng Siong is able to collect cash from its customers after billing them in 6.6 days.
Debtor Days 2019
= Trade Receivables / Revenue x 365 days
= S$ 17.981 million / S$ 991.284 million x 365 days
= 6.6 days
Ratio #6: Inventory Turnover Days
Inventory turnover days tell us how fast a stock is able to turn its raw materials after purchasing them, transform them into sellable products and services, and have them sold to customers. It is calculated by the formula below:
Inventory Turnover Days = Inventories / Cost of Sales x 365 days
The figure for inventories can be obtained from its balance sheet. Meanwhile, its cost of sales figure can be obtained from its income statement. In 2019, the company has S$ 82.166 in inventories and has spent S$ 724.426 million in cost of sales. Thus, its inventory turnover days is 41.40 days. It means, Sheng Siong took 41.40 days to turn its raw materials into products it can be sold (inventories) and sold it to its customers.
Inventory Turnover Days 2019
= Inventories / Cost of Sales x 365 days
= S$ 82.166 million / S$ 724.426 million x 365 days
= 41.4 days
Ratio #7: Creditor Days
Creditor days are the opposite from debtor days. It tells us how soon a stock pays off its bills for buying their raw materials from its suppliers. It is calculated as follows:
Creditor Days = Trade Payables / Cost of Sales x 365 days
Trade payables can be obtained at current liabilities in its balance sheet. Cost of sales can be obtained in a company’s income statement. In 2019, Sheng Siong’s trade payable is S$ 140.766 and it has spent S$ 724.426 million in cost of sales during the year. Thus, its creditor days are 70.9 days. It means, Sheng Siong took 70.92 days to pay off its creditors after being billed by them for its purchases of raw materials.
Creditors Days 2019
= Trade Payables / Cost of Sales x 365 days
= S$ 140.766 million / S$ 724.426 million x 365 days
= 70.9 days
Ratio #8: Cash Conversion Cycle (CCC)
CCC tells us how long it takes for a stock to convert its raw materials purchased into inventories, sell them to its customers, collect cash from them and finally, settle payment to its suppliers for its raw materials purchased. It is calculated as follows:
= Debtor Days + Inventory Turnover Days – Creditor Days
= 6.6 days + 41.4 days – 70.9 days
= -22.9 days
In Sheng Siong’s case, here is how it manages its cash flow:
Sheng Siong has purchased its raw materials from its suppliers. Its suppliers had billed them but Sheng Siong did not settle them immediately.
Day 41+ (Inventory Turnover Days)
Sheng Siong has converted its raw materials purchased into inventories, which were then sold to its customers. Sales had been made.
Day 48 (Inventory Turnover Days + Debtor Days)
Sheng Siong has collected cash payment for inventories sold to its customers.
Days 70+ (Creditor Days)
On the 70th day, Sheng Siong made payments to its suppliers for raw materials purchased.
So, when did Sheng Siong receive cash from its customers? – Day 48
And, when did Sheng Siong pay cash to its suppliers? – Day 70+
Can you see there is a gap of 22.9 days in between cash in and cash out? That is the cash conversion cycle (CCC) for Sheng Siong. The figure is negative because it shows that Sheng Siong is receiving cash first before paying cash out, which is better than having cash paid out first before receiving it.
The above article is meant to introduce the basics of financial ratios so that you can use it to assess the financial health of a company. Mastering the basics is helpful to stock investors as they can use the ratios to identify good stocks and separate them from bad stocks that do not.
So, in summary,