Financial ratios are an important tool for obtaining a clear picture of a company’s financial data, helping you assess its performance and make wise investment decisions, whether you are looking at large-cap stocks or low-value stocks.
What is a ratio?
A ratio involves taking one number from a company’s financial data and dividing it by another number. The result allows you to measure the relationship between the numbers.
Knowing that the stock price is $2.13 doesn’t tell you much, but knowing that the company’s price-to-earnings (P/E) ratio is 8.5 provides you with more context. It tells you that when divided by its earnings per share (EPS) of $0.25 in this case, its price ($2.13) equals 8.5.
You can then compare this P/E ratio to those of large companies, like direct competitors, or even the company’s own data from previous years, to evaluate the stock price relative to its earnings.
Types of Ratios
Ratios provide a picture of various aspects of a company’s financial health, from how it uses its assets to its ability to cover its debts. A single ratio may not provide a complete picture unless it is viewed as part of the whole.
Ratios are sensitive to time, as they measure data that changes over time. You should take that into account when evaluating them. You can gain an advantage by comparing ratios from one time period to another to get an idea of the company’s growth or other changes over time.
Liquidity
Liquidity ratios show whether a company can pay off its debts and other obligations. A company may experience problems if it does not have enough short-term assets to cover short-term debts or if it is not generating sufficient cash flows to cover its costs.
These ratios include the current, quick, and cash liquidity ratios and operating cash flow. The current ratio is current assets divided by current liabilities. It gives you an idea of the company’s ability to meet its obligations in the next 12 months.
The cash ratio tells you how much cash the company has compared to its total assets. The quick ratio, also known as the acid-test ratio, compares the company’s current assets minus inventory to its liabilities. It gives you a better picture of its ability to pay off its current debts.
Activity
Activity ratios show the efficiency of the company. They tell you how the company uses its resources, such as assets, to generate sales. Some ratios you may want to apply in your research include inventory turnover, accounts receivable turnover, accounts payable turnover, fixed asset turnover, and total asset turnover.
Inventory turnover is expressed as the cost of goods sold for the year divided by the average inventory. This can show you how well the company manages inventory relative to sales.
Accounts receivable turnover shows how quickly net sales are converted into cash. It is expressed by dividing net revenue by the average accounts receivable.
Leverage
Leverage ratios (or liquidity) show how capable the company is of repaying its long-term debts. These ratios examine how much a company relies on debt for operations and how likely it is to meet its obligations. Common financial ratios include the debt ratio, debt-to-equity (D/E) ratio, and interest coverage ratio.
The debt ratio compares the company’s debt to its total assets. The debt-to-equity ratio looks at the company’s total debt compared to the equity provided by investors. A lower number is considered safer with this ratio, although it can also mean a very conservative and recognized company if it is too low.
Performance
Performance ratios tell you about the company’s earnings. They are often referred to as “profitability ratios.” They provide a clear picture of profitability at different stages of operations. Profitability ratios include gross profit margin, operating profit margin, net profit margin, return on assets, and return on equity.
It will show you
The gross profit margin compares total sales to profits. Subtract the cost of goods sold from total revenue, then divide it by total revenue to arrive at this figure.
The operating profit margin shows the company’s earnings before taxes and interest payments. Divide operating profit by total revenue.
Valuation
Valuation ratios depend on the company’s current share price. They provide a picture of whether the stocks are a good buy at current levels. How much cash or working capital or cash flow or profits do you get for every dollar you invest? They are also referred to as “market ratios” because they measure the strength of the company in the market.
Some valuation ratios include the price/earnings (P/E) ratio, price/cash flow ratio, price/sales (P/S) ratio, and price/earnings/growth (PEG) ratio.
Using Ratios in Analysis
Ratios give you a way to compare companies. They also allow you to track the performance of a particular company over time, but don’t base your choices on just one ratio. Look at them as a whole. Valuation ratios can make all the difference in your results, giving you the detailed data you need to uncover issues before investing.
FAQ
What is the best type of financial ratio to measure the ability to meet daily cash needs?
The quick ratio and other liquidity ratios tell you how quickly a company can access cash to meet short-term obligations. If an unexpected expense arises that the company needs to cover with cash or cash-equivalent assets, liquidity ratios will analyze the company’s ability to handle this cost.
What ratio shows earnings after taxes on a per-share basis?
The earnings per share (EPS) ratio tells you the company’s net earnings per share. It takes into account taxes and other costs that can affect profits. It does not consider the taxes you will pay on dividends and capital gains, so you will need to take additional steps to calculate how the tax rate affects your earnings.
Source: https://www.thebalancemoney.com/types-of-financial-ratios-2637034
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