Financial Ratios Every Investor Should Know

Understanding financial ratios is crucial for investors to assess a company’s financial health and performance. Here are some key financial ratios every investor should know, categorized into profitability, liquidity, solvency, and efficiency ratios.

1. Profitability Ratios

            a. Net Profit Margin

• Formula: Net Profit Margin = Net Revenue/Revenue
• Purpose: Measures the percentage of revenue that remains as profit after all expenses are deducted.
• Insight: Higher net profit margins indicate more efficient cost management and profitability.

           2. Return on Equity (ROE)

• Formula: ROE = Net Income/Shareholders’ Equity
• Purpose: Evaluates the return generated on shareholders’ investments.
• Insight: High ROE indicates efficient use of equity to generate profits.

           3. Earnings Per Share (EPS)

• Formula: EPS = Net Income-Dividends on Preferred Stock/Average Outstanding Shares
• Purpose: Indicates the portion of a company’s profit allocated to each outstanding share of common stock.
• Insight: Higher EPS suggests better profitability and value for shareholders.

           4. Liquidity Ratios

            a.Current Ratio

• Formula: Current Ratio = Current Assets/Current Liabilities
• Purpose: Measures a company’s ability to cover its short-term liabilities with its short-term assets.
• Insight: A ratio above 1 indicates good liquidity, while below 1 suggests potential liquidity problems.

           5.Quick Ratio (Acid-Test Ratio)

• Formula: Quick Ratio = Current Assets-Inventory/Current Liabilities
• Purpose: Similar to the current ratio but excludes inventory, providing a more stringent test of liquidity.
• Insight: A higher quick ratio indicates better immediate liquidity.

           6.Solvency Ratios

           a.Debt to Equity Ratio

• Formula: Debt to Equity Ratio = Total Liabilities /Shareholders’ Equity
• Purpose: Assesses a company’s financial leverage and ability to meet its long-term obligations.
• Insight: A lower ratio indicates less leverage and lower financial risk.

           7.Interest Coverage Ratio

• Formula: Interest Coverage Ratio =EBIT/Interest Expense
• Purpose: Measures how easily a company can pay interest on outstanding debt.
• Insight: A higher ratio suggests strong capability to meet interest obligations.

           8.Efficiency Ratios

           a.Inventory Turnover Ratio

• Formula: Inventory Turnover Ratio =Cost of Goods Sold/Average Inventory
• Purpose: Shows how many times a company’s inventory is sold and replaced over a period.
• Insight: Higher ratios indicate efficient inventory management.

           9.Accounts Receivable Turnover Ratio

• Formula: Accounts Receivable Turnover Ratio =Net Credit Sales/Average Accounts Receivable
• Purpose: Measures how efficiently a company collects its receivables.
• Insight: Higher ratios suggest efficient collection processes.

           10.Market Ratios

            a.Price to Earnings (P/E) Ratio

• Formula: P/E Ratio= Market Price per Share/Earning per share
• Purpose: Valuates a company’s current share price relative to its per-share earnings.
• Insight: Higher P/E ratios may indicate expectations of future growth, while lower ratios may suggest undervaluation.

           11.Price to Book (P/B) Ratio

• Formula: P/B Ratio = Market Price per Share/Book Value per Share
• Purpose: Compares a company’s market value to its book value.
• Insight: A lower P/B ratio may indicate an undervalued stock, while a higher ratio may suggest overvaluation..

Conclusion

Understanding these key financial ratios can provide valuable insights into a company’s financial health, performance, and potential investment risks. By incorporating ratio analysis into your investment strategy, you can make more informed decisions and identify high-potential investment opportunities.