The financial ratios are used by investors to do a quantitative analysis of a company.
Financial ratios are used to get a birds-eye view of the finances of a company. Which makes investor’s work easier before proceeding with further research.
Understanding each & every ratio is important for every investor as it can save a lot of time & energy.
At the same time provide good quality information about the fact of a company.
11 Financial ratios every investor should know.
1.P/E Ratio or Price to earning ratio.
P/E ratio is the most popular ratio used by investors for valuing a company.
This ratio simply means how much an investor is willing to pay for $1 of earnings of a company.
Two types of P/E ratios include Forward P/E and Trailing 12 months P/E TTM.
Forward P/E ratio is an estimate of the next 12 months earning to current price & TTM P/E ratio is based on past period information.
2.P/B or Price to Book value.
This ratio is measured by dividing the current share price by the book value per share.
Here the book value includes net tangible assets minus all intangible assets (goodwill, patents, etc.) & all liabilities.
Price to Book ratio simply implies how much an investor is willing to pay for $1 of net assets of a company.
Generally, a lower P/B ratio means undervalued stock and vice versa.
3.ROE or Return on Equity.
ROE is considered as a measure of how effectively the management of a company is using shareholder’s money to generate profit.
Shareholders Equity=Paid-up share capital+ Retained earning+ Other capital raised. Net profit = Profit after tax (PAT).
Return on equity is the return received by the shareholders of a company.
This ratio excludes the debt element, thus it should be always checked with the debt elements on the Balance sheet.
4.ROCE OR Return on Capital Employed.
ROCE describes how much a company earns on every $1 of invested capital i.e. equity & debt.
This financial ratio should be one of the most important factors in investing in any company.
As higher ROCE will help to compound money faster
Companies with high ROCE mostly have a good competitive advantage.
5.CR or Current Ratio.
The current Ratio tells whether a company can survive a short-term cyclical downturn or recession.
Fund available with companies to pay off its debt obligation due within one year. The ideal Current Ratio can be different for different industries.
(CA) Current Assets = these assets are invested for a period of one year.
(CL) Current Liabilities = these liabilities are needed to be paid within a year.
6.QR or Quick Ratio.
Quick Ratio excludes inventory from Current assets because the inventory of many companies cannot be liquated fast.
This ratio is used instead of the Current asset.
The higher quick ratio is most useful in the time of crises like Covid-19. It provides additional comfort to a company to bear the short-term pain.
Vice versa for a lower quick ratio.
D/E Ratio measures how much debt a company has borrowed has against its $1 of Shareholders Equity.
Companies having a higher D/E ratio can be a red flag to an investor.
This ratio is also sector-specific. For Eg:- IT companies have a lower D/E ratio whereas manufacturing companies can have a higher D/E ratio.
8.ICR or Interest coverage ratio.
This financial ratio measures, the financial ability of a company to pay off its interest on outstanding liabilities.
Companies having a lower interest coverage ratio can be risky for investors. This could also bring higher interest debt later on.
Interest coverage ratio should be checked with all other factors like sector, interest rate, loan types, etc.
9.Operating Margin Ratio.
The operating margin ratio measures how much a company earns from $1 of sales
It helps investors understand how a company making money; whether from core operation, or other means, such as investment.
A listed stock dividend yield means how much a company pays out as a total cash dividend in relationships with the current share price.
Many companies do not have dividend yield as they reinvest their profits.
So it totally depends on an investor whether he wants to invest in a low or high dividend company.
A consistent and growing profit along with dividends is considered a good investable company.
This ratio is the inverse of the P/E Ratio & also used for valuation. Earnings Yield is the 12 months earning divided by the price.
Generally, a lower-earning yield may indicate that a stock is overvalued and vice versa.
For eg:- Earning per share of a company is 10 and the current share price is 100. Therefore the earning yield of the company is 10% (10/100*100)
Conclusion for financial ratio’s
In this article, we learned about the most important financial ratios every investor should know before investing.
But these financial ratios are not conclusive proof that a company would be a good investment. An investor should read at least 10 years of annual reports and understand a company’s business model, associated risks, sector risks, etc.