Financial Ratios can be intimidating however once understood, it has the possibility of opening a whole new world to investing. It’s important to test stocks on various standards and quotients and understanding such details will bring forth interpretations that can completely change the way one perceives a firm.
These numerical derivations and formula can change your perception of how you look at the investment goals and measures. To be frank, it’s actually like adding a mathematical spice to your investment decision mix.
These financial ratios are majorly categorized into Valuation-Profitability-Liquidity-Efficiency-Debt pointers. But through this topic we will discuss a few of the must-know ratios which will enable you to efficiently maneuver through the sea of shares and option, and consider the right investment plan for you and your financial risk and return package.
Important Financial Ratios: Stock Investing Made Easy
Here are some basic but very crucial financial ratios that every investor must know, and these are quite simple to understand as well. So, let’s learn about the useful financial ratios one by one.
Liquidity Ratios
1. Current Ratio:
This ratio serves as a proof of a corporation’s ability to cover immediate obligations such as current debt or other payables, with resources at hand. It’s calculated as the value of current assets to current liabilities. It is also referred popularly as the Working Capital Ratio.
Current Ratio = Current Assets / Current Liabilities
Learn more about Current ratio and Embed this FREE Current Ratio Calculator.
2. Quick Ratio:
It helps investors to comprehend the extent to which the current or short term liabilities can be paid off with the liquid assets at hand minus the inventory, as it assumes selling the inventory might take more time than available. Also known as “acid test” ratio, similar to the current ratio, however is considered a much more reliable financial number to measure financial strength.
Quick Ratio = (Current Assets – Inventories)/ Current Liabilities
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Profitability Ratios
3. Gross Profit Margin:
It is regularly used to calculate the financial well-being of an organization by revealing the actual profit available after removing the cost of goods sold. It tells a trader how much margin is left before deducting expenses related to marketing, administration, payroll and so on. This analysis can be employed to compare business models and review the ones that have an edge in the industry and is worth the investment.
Gross Margin Ratio = Gross Profit / Net Sales
4. Operating Margin Ratio:
It is the overall profit a business produces from its operations before other elements such as dividends, income taxes, etc. that needs to be paid divided by the net sales. This measures how effective a firms’ profit generation capacity excluding the effects of taxes and other related financial decisions.
Operating Margin Ratio = Operating Income / Net Sales
5. Net Profit Margin:
A profitability ratio used to determine the overall efficiency of a company. A higher net profit margin ratio describes how efficiently the business is converting its revenue into profits. This is represented in percentage and is multiplied by 100.
Net Profit Margin = Net Profit / Net Sales
where, *Net Profit = Net Operating Profit Before Interest and Tax and *Net Sales = Cash Sales + Credit Sales
6. Return on Equity Ratio (ROE):
It’s one of the most applied financial ratio to analyze the profit earned by a business from its stockholders’ investments or shareholder equity. It’s Return on Equity a valuable indicator to understand how excellent the management is at utilizing these funds to develop and build the company’s operation.
Return on Equity Ratio = Net Income/Shareholder’s Equity
Leverage Financial Ratios or Debt Ratios
7. Debt to Equity Ratio:
It helps to evaluate the capacity of shareholder equity in covering debts during a downward spiral. It’s readily used in corporate finance to realize a company’s actual leverage and the risks to shareholders.
Debt to Equity Ratio = Total Liabilities / Shareholders Equity
8. Interest Coverage Ratios:
In this age of credit, many enterprises are run on debt and the investor has the responsibility to weigh the ability of the venture to cover the interest payments incurred on its debt, to measure its growth prospects.
Interest Coverage Ratio = Operating Income (or EBIT) / Interest Expenses
Efficiency Ratios
9. Asset Turnover Ratio:
It estimates how well the firm utilizes its assets to generate sales. A low asset turnover ratio means the assets are not being used cost-effectively to create sales and could be a concern for investors.
Asset Turnover Ratio = Net Sales / Average Total Assets
Other efficiency ratios include:
10. Inventory turnover ratio = Cost of goods sold / Average inventory
11. Receivables turnover ratio = Net credit sales / Average accounts receivable
Price Ratios or Market Value Ratios
12. Price-to- Earnings Ratio or P/E Ratio:
Simply termed as P/E pointer in the trading circles, it is regarded to ascertain if a stock is overrated or underrated. It helps investors find growth companies to achieve a sustainable return on their investment, while understanding if they are paying a fair price for owning it.
P/E Ratio = Price per Share/ Earnings per Share
Learn more about Price to earnings ratio and try this FREE P/E Ratio Calculator.
13. Price-to-Book Value Ratio:
It’s a comparison of the market price of the stock to its book value or net assets. The book value is usually recorded in the disclosed financial statements, while the share price is how the market values the enterprise. There is a possibility that the stock might be overvalued or undervalued, and this helps to evaluate that perception.
P/B Ratio = Price per Share / Book Value per Share
14. Dividend Payout Ratio
It is the percentage of profit a company distributes in the form of dividend to its shareholders.
Dividend Payout Ratio = Dividend / Net Income
15. Earning Per Share or EPS:
EPS is a key metric of a company’s earnings. When you divide the net profit generated by the number of shares
Earnings per share Ratio = Net Earnings / Total Shares Outstanding
These key financial ratios build a baseline for understanding the companies standing in relation to the current market conditions and fluctuations. Although this information is widely available, many investors don’t take advantage of them and are unable to build wealth. They still depend on market perceptions without doing their own homework, which marks the foundation of fundamental analysis.
It’s all about a minor effort to understand these measures and implement it wisely to your money bucket to get better and improved results. Once equipped, an investor can attain heights of clarity which puts one on the path to success in investing.
Now, that was our collection of important financial ratios. Do you wish to discuss any other ratio here, feel free to share in comments.