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.
- 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.
