There are so many financial ratios, it’s challenging to know which of them matter the most. Understanding a few of the most basic ratios will allow an investor to determine if additional scrutiny is warranted. Fortunately, all financial ratios use simple arithmetic learned by second grade. The key is understanding the message a particular ratio delivers.
The entire story of a company is never revealed by the numerous financial ratios, but a lot of valuable information can be discovered and applied to make a final investing decision.
Understand the most important financial ratios:
- Price-to-Earnings Ratio (P/E). This is the price of a share of stock divided by the earnings per share of stock. It’s the amount of money you’d be willing to pay for $1 of earnings.
- If a share of a company’s stock is selling for $40 and the earnings are $2/share, the P/E would be 20. An investor willing to purchase this stock is willing to earn $1 for every $20 invested.
- Debt-to-Equity Ratio. The debt-to-equity ratio is measure of the debt capital used by the company to finance its operations compared to the equity capital being used. So, if the ratio were 1.0, that would mean that the company’s creditors theoretically have a claim to all of the company’s assets. Nothing would be left for the shareholders.
- Debt-to-Equity Ratio = (short term debt + long term debt) / shareholders’ equity
- Return on Equity (ROE). ROE is the amount of income the company generates against the amount of shareholder investments. It measures how efficiently shareholder investments are utilized to generate income.
- ROE = Net income / total shareholders’ equity
- Return on Assets (ROA). ROA is net income divided by total assets. It’s a measure of how effectively a company can turn its assets into income. For example, an office chair sitting in a closet is an asset, but it’s not generating income for the business. The same can be said for unnecessary equipment, marble lobbies, and other luxuries.
- The Current Ratio is a measure of a company’s current assets versus its current liabilities. A high ratio suggests that a company has plenty of cash and liquid assets on hand to deal with any bills. But it’s important to be careful and understand why the current ratio is high. A stockpile of unsold inventory can raise the ratio and be a sign of trouble.
- A low current ratio suggests that the company could struggle to meet its short-term liabilities and suffer from a shortage of cash.
- Net Profit Margin is calculated by dividing the net income by the net revenue. This is the amount of profit generated by each dollar of sales. Some companies make much more profit per $1 of sales than others. Real estate and health care are often mentioned as industries with high profit margins.
- Dividend Yield is also called the dividend-price ratio and = (dividend per share / price per share). Dividend payments can be viewed by investors as cash flow to investors. Companies with a higher dividend yield have the potential to be more attractive to investors than those with lower yields.
Financial ratios aren’t just for financial professionals. Understanding financial ratios is necessary to invest in stocks if you’re doing your own research. They provide a quick view into the financial status and future of a company. It’s not possible to successfully make investing decisions with financial ratios alone, but these ratios are an excellent place to start.