Valuing a business involves determining the economic value of a business. Valuation is an important part of decision-making, whether it involves acquiring, merging, investing, or analysing finances. Financial ratios provide accurate information that analysts use to estimate a company’s worth based on its profitability, liquidity, solvency, efficiency, and market performance. These ratios transform financial data into meaningful information and help investors estimate the health, growth opportunities, and risk of the company. Understanding key financial ratios in business valuation is crucial for professionals, investors, and business owners alike.
Financial Ratios Required for Valuing a Business in India
1. Profitability Ratios
Profitability ratios are used to determine the efficiency with which a business makes its profits from business operations. Large profitability means higher performance, effective management, and prospects of better valuation.
a. Gross Profit Ratio
Gross profit ratio is a ratio that compares gross profit to net sales, which differentiates the efficiency of business production on costs and the amount of goods produced.
Formula: (Gross Profit/Net Sales) x 100.
An increase in the gross profit ratio is a sign of excellent management and an increase in the margins, which adds business value.
b. Net Profit Ratio
The net profit ratio is a ratio that shows the percentage of net profit generated on total revenue after all expenses.
Formula: (Net Profit/ Net Sales) x 100.
It is a reflection of general profitability. A high net profit ratio means that the firm is stable and is highly efficient in its management; both factors enhance the valuation of a firm.
c. Return on Assets (ROA)
ROA indicates the efficiency of a company in terms of utilizing its total assets in order to make profits.
Formula: Net Profit/Total Assets x 100.
Having high ROA means that the business is efficiently using its resources and this will attract investors and increase the value of the business.
d. Return on Equity (ROE)
ROE shows the extent of profit generated by the company through the equity of the shareholders.
Formula: (Net Profit/ Shareholders Equity) x 100.
A high ROE implies the increased use of the investor’s funds and shows that the company can give good returns, thereby enhancing its valuation.
2. Liquidity Ratios
Liquidity ratios are used to identify the capability of a business to fulfil its short-term commitments. Good liquidity of a business means that the business has lower risk and is more valuable.
a. Current Ratio
The current ratio is used to determine the capacity of the company to offset its short-term debts using its current assets.
Formula: Current Assets/ Current Liabilities.
Financial stability is depicted by an ideal current ratio (approximately 2:1). The more the company is liquid, the better it is for investors because the solvency risk is minimal.
b. Quick Ratio
The quick ratio/acid-test ratio is used to determine how the company can cover short-term liabilities without the need to sell inventory.
The formula is (Current Assets- Inventory)/ Current Liabilities.
A ratio higher than 1 signifies a good liquidity position that gives more confidence to the investors, and thereby increases the valuation of the company.
3. Solvency Ratios
The solvency ratios assess the ability of a company to fulfil its long-term debts, as well as other financial obligations. They show the degree of leverage or financial dependence of the business.
a. Debt-to-Equity Ratio
The debt-to-equity ratio is a comparison of the total liabilities of a company with the equity of the shareholders.
Formula: Total Debt/Shareholders’ Equity.
The lower the ratio, the less the reliance on borrowed money and the greater the financial stability. Investors would choose those companies that have an average or low debt-to-equity ratio because it indicates that they are stable in the long term.
b. Interest Coverage Ratio
The interest coverage ratio is used to determine how the company can comfortably cover its interest commitment on the debt that is outstanding.
Formula: EBIT/ Interest expense.
The higher the ratio, the better, the more the business can make to meet the interest payments without incurring the risk of being insolvent. This is a good move for lenders and investors, and it is boosting the valuation of the business.
4. Efficiency Ratios
The efficiency ratios are used to show the ability of the company to use its resources and assets to make sales. Better operational performance and profitability are indicated by high efficiency ratios.
a. Inventory Turnover Ratio
It is a ratio of the number of times a company sells and replaces inventory in a period.
Formula: Cost of Goods Sold/Average Inventory.
When it has a high inventory turnover ratio, it indicates good inventory management, and high demand for the product is another factor that would lead to an increase in valuation.
b. Debtors Turnover Ratio
The debtor’s turnover ratio is the speed at which cash is collected by the company from its customers.
Formula: Net Credit Sales/ Average Accounts Receivable.
The larger ratio shows that the company has a sound credit policy and good cash flow, which is value-adding to the business.
c. Total Asset Turnover Ratio
The total asset turnover ratio indicates the efficiency of a company in utilizing its assets to create revenues.
Formula: Net Sales/Total Assets.
The increase in ratios represents good utilisation of the assets and improved profitability, which in turn has a positive effect on valuation.
5. Market-Based Ratios
Ratios based on market show the perception of the investor and are used to determine the market value of a company. They are important in determining the underpricing or overpricing of a stock or business.
a. Earnings Per Share (EPS)
EPS is used to determine the amount of profit that is associated with every share of stock.
Formula: Net Profit After Tax/ Number of outstanding shares.
An increase in EPS indicates that the company is generating good returns to its shareholders and this increases investor confidence and increases valuation.
b. Price-to-Earnings (P/E) Ratio
P/E ratio is a comparison of the price per share in the market of a company to the earnings per share.
Formula: Earnings/Share/ Market Price per share.
An increased P/E ratio implies that the investors are optimistic about the growth of the company. It belongs to one of the most common ratios to assess publicly listed companies.
Conclusion
Business valuation is based on financial ratios and metrics. They make complex financial information easier to understand and convert into actionable insights. Every ratio, whether it is profitability, liquidity, solvency, efficiency, or market performance, is crucial in showing the true value of the company.
No single ratio can fully determine a company’s value, but a combination of ratios offers a more holistic analysis. Through the analysis and use of these valuable financial ratios to determine a business’s value, analysts and investors can make informed conclusions about a company’s performance, risk profile, and future outlook.
Finally, getting a command of these ratios not only assists in the correct valuation of businesses, but it also results in fewer financial planning and strategic decision-making as well as sustainable growth.
