Financial ratios are widely used by smart investors who want to dig deeper into a stock before investing. Financial ratios are exactly, what they are, mathematical calculations based on different variables used to reveal the intricate details of how a business is run. More specifically, financial ratios are used to give the investor an overall valuation of the company. The investor can then decided whether they should buy a stock based on comparing their valuation to the stock’s price.
Financial ratios are used mostly in the fundamental analysis of stocks and some consider this to be an art than a science. This is due to the fact that financial ratios can mean different things to different people and thus, there is a very high likelihood that different investors will come up with different valuations for the same company, despite using the same financial ratios.
While financial ratios are only a small part of the story, they can reveal a lot more information about the way the business is run. Investors need to focus on other aspects such as the economy, the industry trends, sales and revenue and so on to draw a full picture.
The starting point for any financial ratio is to being by looking at the financial statements, balance sheets, cash flow statements, income statements for a company for a given period of time. The financial statements typically have various sections, for example:
- Assets and Liabilities
- Sales Revenue
- Gross Profits
- Operating expense
- Operating profits
- Net profits before taxes
- Net profits after taxes
- Stock dividends
Types of financial ratios
Most financial ratios can be categorized into one of the following types and when combined, they give a full picture of the company. It is up to the investor on how many of the financial ratios they would like to use to value a business and at times it can get overwhelming.
Price ratios are used to determine the relative value of the stock price, meaning whether the stock is over-valued or under-valued. Price ratios are ideally used to compare one stock to another within a sector. A common example is comparing price ratios
Profitability ratios are the second type of financial ratios that show you whether a business is efficient in making profits. Profits for a company is the eventual bottom line that drives the stock price higher and such type of ratios give a very good idea on the profitability of a company.
Liquidity ratios are the next type of financial ratios which tells the investor on the ability of a business to meet its short term obligations. Liquidity is an important part of running a business as it helps a company to wade through a crisis, or to pay its debt obligations.
Debt ratios, as the name suggests has to do with determining the long term health of a business and the effect of capital and financing structure of the business.
Efficiency ratios tell the investor how well a business is utilizing its resources invested in fixed assets such as machinery, buildings, equipment and so on as well as the efficiency of the working capital.
There are many different types of financial ratios available, but the following top 10 are the most widely followed and used financial ratios when it comes to investing in the stock market.
1. Price to earnings ratio (P/E)
The P/E ratio is the price of a stock divided by its earnings. The P/E ratio tells you the price you pay for every $1 of earning made from the stock. With P/E ratio, a lower value is ideal, meaning that an investor always prefers to pay a low price to get higher earnings. P/E can vary from one industry to another and there is no fixed number for this value. To calculate the P/E ratio, you need to look at the income statement and the stock chart to get the latest price. P/E ratio falls under the category of price ratio.
For example, if a company reports basic or diluted earnings per share (EPS) of $5.54 and the stock is trading at $110, then the Price to earnings ratio is around 19.80.
The above ratio says that for $1 in earning, investors need to pay $19.80 for $1 in earnings from Disney.
2. Price to earnings growth ratio (PEG)
The PEG ratio is based on the P/E ratio and further divides the P/E ratio by the potential growth for earnings per share. It was made famous by Peter Lynch, in his book One up on Wall Street in 1989. PEG ratio is understandably closely related to the P/E ratio and is part of the price ratio family. The PEG ratio also accounts for the future growth potential of the company. In a very broad sense, PEG ratio of 1 or lower is better for valuation with a PEG ratio of 1 is said to infer that the company is at fair value. To determine the PEG ratio, investors need to look at the P/E ratio which is based off the income statement and the stock chart.
3. Price to book ratio (P/B)
Price to book value shows the amount you have to pay to own $1 of equity. It is similar to Price/Earnings ratio except that book value per share is considered rather than the share price. Book value is already listed on the balance sheet and is also known as shareholder equity, which is the portion of the company that stock holders own.
4. Return on Assets (RoA)
The return on assets shows how well a company is utilizing its assets to make money. For example, if a company buys equipment or a building, the RoA is used to show the efficiency of the assets. The Return on Asset is derived as dividing the net income by the average total assets, the values of which are derived from the income statement and the balance sheet.
5. Profit margin
The profit margin is a commonly used profitability ratio which calculates the sales that flow through to the company’s bottom line. Higher or increasing profit margins are of course preferred by shareholders and the value is based on dividing the net income by the sales.
6. Current Ratio
Current ratio is used to measure the company’s ability to pay its short term liabilities by using its short term assets. The figure is represented as a number and it is generally accepted that a current ratio of 1.0 or higher indicates that the business has more short term assets than debts. A value of less than 1.0 indicates a business has higher debts than short term assets. The current ratio will show the business vulnerability to any downturn in the economy or in the industry sector. Current ratio is calculated by dividing the current assets by current liabilities, both these values are found in the balance sheet.
7. Quick Ratio
Quick ratio is also referred to as the acid-test ratio for a company. It is similar to the current ratio as it shows how well a company can meet its short term debt or liabilities with the difference being that the quick ratio does not account for inventory as it is not considered as immediately available cash or an asset. The quick ratio is calculated as the difference between the current asset and inventory divided by the current liabilities.
A company having quick ratio of less than one means that the company is facing problems to pay back its current liabilities and thus should be avoided at all costs.
8. Debt-to-Equity Ratio
The Debt to equity ratio falls under the debt ratio category and it measures the relationship between the capital that was borrowed and the capital contributed by shareholders, as the name suggests. The debt to equity ratio is also referred to as leverage or gearing. There is also the argument of how allocate the preferred stock which can be either debt or equity, thus bringing some subjectivity to this ratio. A rising debt-equity ratio means that it is more risky for a company as it becomes difficult to meet its debt obligations. The debt to equity ratio is calculated by dividing the total liabilities by the total share holder equity.
9. Asset turnover ratio
The Asset turnover ratio is calculated by dividing the sales by the average total assets. It is similar to the return on asset but falls under the efficiency ratio. Thus it gives investors insight into how effectively a business is being run. The asset turnover ratio measures how good the company is using its assets to make products. The asset turnover ratio is represented as a multiple. So a ratio of 2 indicates that for every $1 in asset owned, the company generates $2 in sales.
To measure the asset turnover ratio, you need the sales and the average total assets, the values of which can be found in the income statement and the balance sheet.
10. Inventory turnover ratio
As the name implies, inventory turnover ratio focuses on measuring how quickly a company can sell its inventory. Typically a higher turnover in inventory is preferred as it can point to slower backlogs or stockpiling of the inventory. The inventory turnover ratio is derived by dividing the cost of goods sold by the average inventory. Both these values can be found in the company’s income statement as well as the balance sheet. Inventory turnover ratio can be mixed at times especially when you look at retailer stocks, where higher inventory turnover is seen during the peak shopping periods.
Using financial ratios in stock screeners
The above 10 financial ratios should help the investor gain a more decent understanding of the stock that they want to invest. While financial ratios can be overwhelming at times, investors should bear in mind that the ratios are all based out of numbers in the financial statements of the stock and the company. An investor can focus on some of the key ratios and use this to quickly build a stock scanner based on their custom filters.
The above stock screener for example lists mid cap stocks and higher in the U.S. with a stock price of under $50 having a price to book value of less than 1 with quick ratio and current ratio above 2.
The above mentioned top 10 financial ratios are not set in stone and can change over a period of time, especially when more and more technology companies are starting to replace the traditional manufacturing and consumer products oriented companies. Thus, it won’t be surprising to expect the inventory turnover ratio to be out of sync when more and more digital companies start to dominate the stock market indexes.
Financial ratios can be used by the investor to determine the health of a company and more importantly to use the metrics to compare companies. In most cases, financial ratios are used by businesses to evaluate and benchmark their performance or progress and these same methods are also used by investors before they invest in a company.
While financial ratios are a great way to gauge a company’s health, they are in no means indicative of the future potential of the company as they only give estimates. Thus, financial ratios are limited in a way. For large businesses that run different departments such as health care, consumer staples and so on, researching into the financial ratios can bring mixed results due to the diversity of the business. Seasonal factors are also something to bear in mind which tends to distort the financial ratios.
A good example of this is retailers who experience a surge in business during the Christmas season. Furthermore, financial ratios can make business valuation tricky if used at the same time. For example a company’s financial ratios can be mixed making it difficult for the investor to understand if it is a good business to invest in or not.
With due practice and having enough patience, investors can start looking at the financial ratios which can be a good starting point in become more active as an investor. As with everything, financial ratios alone do not give the full picture and investors should focus on the broader markets as well, but as far as the fundamental analysis goes, the above top 10 financial ratios should make for a good starting point.
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