Learning how to read and understand key financial ratios is an important step in stock investing. You need to know what they mean and what they can tell you, even if you get the ratio numbers from your broker or a website. You can make mistakes without this knowledge, such as investing in a company with a lot of debt or paying too much for a stock that isn’t delivering good earnings growth.
Price to Cash Flow Ratio
Some investors prefer to focus on the price to cash flow ratio instead of the more well-known price to earnings ratio. It is calculated by dividing the market value of the company by its cash flow or dividing the share price by the cash flow from operations per share.
Price to Earnings Ratio
The price to earnings ratio, or P/E, is perhaps the most famous ratio in the world. It’s a quick and easy way to see if stocks are cheap or expensive compared to their peers. The P/E is the amount of money the market is willing to pay for each dollar of earnings generated by the company. You have to decide whether this amount is too high, a good deal, or somewhere in between.
PEG Ratio
The PEG ratio goes a step further than the P/E ratio. It takes into account the expected growth rate of the company’s earnings. It may be a better indicator than the simpler price-based ratio for determining if stocks are cheap or expensive.
Asset Turnover Ratio
This ratio measures the revenue generated by the company for each dollar of assets it owns. It is a good way to assess how efficiently the company is using its assets compared to its peers.
Current Ratio
Like the price to earnings ratio, the current ratio is one of the most well-known ratios. It is a test of financial strength. It can give you an idea of whether the company has a lot or a little cash on hand to meet its obligations. It is calculated by dividing current assets by current liabilities.
Quick Ratio
The quick ratio is another way to help you determine a company’s financial strength. It is also known as the “acid test.” As the name suggests, it is a stricter measure of the company’s ability to meet its obligations. Inventory is subtracted from current assets before dividing by current liabilities. The idea is that the company may take a long time to convert its assets to cash before they can be used to cover what it owes.
Debt to Equity Ratio
The debt to equity ratio allows you to compare the company’s total equity (the amount its shareholders have invested in the company plus retained earnings) to its total liabilities. Total equity is sometimes considered the net worth of the company from the owners’ perspective. By dividing the company’s debt by this equity—doing the same for others—you can see how highly leveraged it is compared to its peers.
Gross Margin
Gross margin tells you how much of the company’s profits are available as a percentage of revenue to cover its expenses. It is calculated by subtracting the cost of goods sold from total sales, and then dividing the result by total sales.
Net Margin
Net margin tells you how much profit the company makes per dollar of revenue it generates. If the company’s net margin is 0.14, then the company makes 14 cents of profit for every dollar of revenue.
Interest Coverage Ratio
The interest coverage ratio is important for companies that carry a lot of debt. It tells you the amount of money available to cover the interest expenses the company incurs on the money it owes annually.
Operating Margin
Operating income is gross profit minus operating expenses. It is the gross profit before taxes that the business generates from its operations. It can also be described as the money available to business owners before they have to pay certain items, such as preferred dividends and income taxes. The operating margin for a company is calculated by dividing operating income by revenue. It is a way to measure the company’s efficiency.
Ratio
Accounts Receivable Turnover
The sooner customers pay their invoices, the sooner the company can use that cash. The accounts receivable turnover ratio is a useful way to know how many times a business collects its accounts in a year. You will get the average number of days it takes to receive payment if you divide that ratio by 365.
Inventory Turnover Ratio
You can find out how many times the company converts its inventory over a period of time using this ratio. An efficient retailer will have a higher inventory turnover ratio.
Return on Assets
Return on assets, or ROA, tells you how much profit a company makes for every dollar of assets it owns. It is calculated by dividing net income by total assets. This number indicates how well the company is using its assets to generate profit. It is most useful when comparing a company’s ROA to its peers.
Return on Equity
A key measure is the return on equity, or ROE. It reveals how much profit the company has generated relative to the total equity of shareholders listed on its balance sheet.
Advanced Return on Equity: DuPont Model
The DuPont model, or DuPont analysis, allows you to analyze return on equity to determine what drives ROE. It can also give you vital information about the company’s capital structure.
Working Capital per Dollar of Sales
The working capital per dollar of sales ratio tells you how much money the company has to conduct its business. The greater the working capital needed by the company, the less valuable it becomes. This is money that business owners cannot withdraw as profits.
Frequently Asked Questions (FAQs)
What are financial ratios?
Financial ratios can be any ratio that gives owners and potential investors insight into the performance of the financial entity. They are important because they allow for more accurate comparisons between companies. Business owners can use financial ratios to target areas needing improvement, and investors can use them to help choose investments.
What are the different types of financial ratios?
Different types of financial ratios can provide different information. For example, some ratios target liquidity-related data, while others focus on efficiency, leverage, performance, or valuation.
Sources:
Corporate Finance Institute. “Price-to-Cash-Flow Ratio.”
U.S. Securities and Exchange Commission. “Price-Earnings(P/E) Ratio.”
Corporate Finance Institute. “Current Ratio Formula.”
U.S. Securities and Exchange Commission. “Beginners’ Guide to Financial Statements.”
Corporate Finance Institute. “Net Profit Margin.”
Board of Governors of the Federal Reserve System. “The Information in Interest Coverage Ratios of the US Nonfinancial Corporate Sector.”
Corporate Finance Institute. “Accounts Receivable Turnover Ratio.”
Stephen M. Ross School of Business. “Inventory Turnover.”
Corporate Finance Institute. “Return on Assets & ROA Formula.”
Source: https://www.thebalancemoney.com/financial-ratio-guide-357501
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