Financial Ratios & DCF Analysis – Understand, Calculate, and Value Your Investments

Financial ratios and discounted cash flow (DCF) analysis provide a deep understanding of how well a business performs and what it's worth. Below are essential ratios every investor and analyst should know—each with a clear definition and easy-to-use formula.

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📊 Liquidity Ratios

1) Current Ratio
Shows how well a company can meet short-term obligations using its short-term assets. A higher ratio means stronger liquidity and financial health.

\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}

2) Quick (Acid-Test) Ratio
A stricter measure of liquidity that excludes inventory from current assets, focusing only on the most liquid resources.

\text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}

⚖️ Leverage Ratios

1) Debt Ratio
Indicates what proportion of total assets is financed through debt. A lower ratio generally reflects lower financial risk.

\text{Debt Ratio} = \frac{\text{Total Debt}}{\text{Total Assets}}

2) Debt-to-Equity Ratio
Compares total debt to total shareholder equity to show how leveraged a company is. High leverage increases both potential returns and risk.

\text{Debt to Equity} = \frac{\text{Total Debt}}{\text{Total Equity}}

💰 Profitability Ratios

1) Net Profit Margin
Reveals how much profit remains from every dollar of sales after expenses. High margins indicate strong cost management and pricing power.

\text{Net Profit Margin} = \frac{\text{Net Income}}{\text{Revenue}}

2) Return on Assets (ROA)
Shows how efficiently a company uses its assets to generate profit. Ideal for comparing companies across capital-intensive industries.

\text{ROA} = \frac{\text{Net Income}}{\text{Average Total Assets}}

3) Return on Equity (ROE)
Measures the profitability generated from shareholders’ invested capital. A higher ROE means greater efficiency in generating returns.

\text{ROE} = \frac{\text{Net Income}}{\text{Average Shareholder's Equity}}

⚙️ Efficiency Ratios

1) Asset Turnover
Shows how efficiently a company uses its assets to generate sales. A higher ratio reflects better utilization of assets.

\text{Asset Turnover} = \frac{\text{Net Sales}}{\text{Average Total Assets}}

2) Inventory Turnover
Indicates how quickly inventory is sold and replaced. Higher turnover implies better inventory management and lower holding costs.

\text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}

📈 Market Value Ratios

1) Price-to-Earnings (P/E) Ratio
Shows how much investors are willing to pay per dollar of earnings. High P/E ratios may reflect growth expectations or overvaluation.

\text{P/E} = \frac{\text{Market Price per Share}}{\text{Earnings per Share}}

2) Market-to-Book Ratio
Compares market value to book value, highlighting how investors perceive the company's net asset worth.

\text{Market to Book} = \frac{\text{Market Price per Share}}{\text{Book Value per Share}}

3) Dividend Yield
Represents the percentage return a shareholder earns from dividends relative to the stock price.

\text{Dividend Yield} = \frac{\text{Annual Dividend per Share}}{\text{Stock Price}}

💵 Cash Flow Ratios

1) Operating Cash Flow Ratio
Measures the ability of operating cash flows to cover current liabilities. It reflects real cash strength rather than accounting earnings.

\text{OCF Ratio} = \frac{\text{Operating Cash Flow}}{\text{Current Liabilities}}

2) Free Cash Flow (FCF)
Shows how much cash remains after essential capital expenditures, available for debt repayment, dividends, or expansion.

\text{FCF} = \text{Operating Cash Flow} - \text{Capital Expenditures}

🧮 Investment Valuation Ratios

1) Earnings per Share (EPS)
Indicates profit attributed to each share of common stock. A growing EPS signals improving profitability.

\text{EPS} = \frac{\text{Net Earnings}}{\text{Outstanding Shares}}

2) Price-to-Sales (P/S)
Useful for evaluating companies with unstable profits; it compares market price to revenue per share.

\text{P/S} = \frac{\text{Stock Price}}{\text{Sales per Share}}

💡 Discounted Cash Flow (DCF) Analysis

1) Discount Factor
Brings future cash flows to present value using a chosen discount rate.

\text{DF} = \frac{1}{(1+r)^t}

2) Present Value (PV)
Calculates today’s value of future payments or income streams.

\text{PV} = \frac{FV_t}{(1+r)^t}

3) Net Present Value (NPV)
Determines whether a project or investment adds value after discounting all cash inflows and subtracting the initial outlay.

\text{NPV} = \sum_{t=1}^{T} \frac{CF_t}{(1+i)^t} - \text{Initial Investment}

4) Terminal Value (Perpetuity Growth Method)
Estimates value beyond the forecast period assuming a constant growth rate.

\text{TV} = \frac{FV_t (1+g)}{r-g}

5) Terminal Value (Exit Multiple Method)
Calculates terminal value using an industry-based valuation multiple such as EBITDA.

\text{TV} = FV_t \times \text{EBITDA Multiple}

6) Enterprise Value (EV)
Represents the total value of a company’s operations regardless of capital structure.

\text{EV} = \sum PV_t + PV_{TV}

7) Equity Value
The residual value available to shareholders after deducting debt and adding cash.

\text{Equity Value} = \text{EV} - \text{Total Debt} + \text{Cash}

🧠 Final Thoughts

Combining financial ratios with DCF analysis provides a complete picture of a company’s performance and intrinsic value.
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Financial Ratios & DCF Analysis – Understand, Calculate, and Value Your Investments

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