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What is Financial Ratio Analysis?
The Financial Ratios are essential elements of any company’s balance sheet, and it creates a numeric value to acquire meaningful information about the company. The relative magnitude of two numeric values of different factors evaluates the overall condition of the particular firm.
While investing in stocks or securities, users require careful observation of the organization’s financial data to find out whether the company is trustworthy or not. The Ratios help access various perspectives of the organization’s performance, including liquidity, turnover, solvency and profitability.
Benefits of Financial Ratios
- Simplify the complicated things and compare a lot of factors present in the companies’ balance sheets.
- Determines the liquidity and long term solvency of the firm.
- Interprets finances of any company with the help of financial ratios.
- Offers significant information regarding the performance of the business.
- Estimates the firm’s budget and examines the previous trends.
- Support in decision making by aiding to analyze the financial records.
- Assists in predicting and planning the trend analysis.
The first step of trading or investing in the Stock Market requires basic analysis that focuses on bringing financial data records of corporations to compute different ratios. These ratios help assess the company value, so here we discuss the most important financial ratios that will help you know the company’s asset value to achieve a great return from your investment.
Top 7 Most Useful Financial Ratios In Stock
1. Price To Earnings Ratio (PE Ratio)
One of the most widely utilized financial ratios is the current share price to earnings per share. In a word, how many rupees did you invest in that company to earn one rupee? It can be expressed as:
P/E= Share Price/ Earnings Per Share
Every sector has a different PE value; it can’t compare with different sectors’ PE. For instance, the PE ratio of the Metal sector varies from IT sector stock PE, so it is irrational to compare different sectors’ PE values.
High PE Value indicates that traders expect high-profit growth from the company, and lower PE means an undervalued company. Generally, if traders are looking for a value stock, the preferable option is to go with a low PE Ratio.
2. Earning Per Share (EPS)
The Monetary value of net earning or profit per outstanding share of the company’s common stock. EPS indicates the company’s profitability, and market investors use this tool to determine the company’s profit yield before investing.
It can find in two ways-
Earnings Per Share = Net Income After Tax/ Number of Outstanding Shares.
Weighted Earnings Per Share = (Net Income After Tax- Total Dividends)/ Number of Outstanding Shares.
High EPS intends a high return on a single share. For traders, it is good to invest in a company that has high and growing EPS.
If you invest in any company for the long term, check the last five years’ EPS ratio. If the value is continuously growing, it is a good option for investment; otherwise, search for other better options.
3. Price To Book Value Ratio (PBV)
The Price Book Ratio gives the relationship between current company value and its book value.
P/B ratio = Market Capitalization/ Book Value
It is used to compare the company’s market price and book value. Book value is the amount of the liquidated company’s assets and repays all liabilities.
With this ratio, investors can recognize the undervalued companies. Many traders and financial analysts consider PB value 3 good, and if the PB ratio is below 1, the company is undervalued. However, less than 1 PB indicates there is some other issue that the company doesn’t show its earnings. Therefore, traders have to look at the other factors of the company.
4. Debt To Equity Ratio (DE)
This ratio shows how much debt involves in the company business, and it calculates the total debt and liabilities to the shareholder’s equity.
Debt To Equity Ratio = Total Liabilities/ Total Shareholder Equity
A low value is considered better. That means if the company has a debt to equity ratio of less than one, your investment is safe or less risky in that company.
Having a debt to equity ratio of more than one value means the company uses more leverage to run its business operations. So, it is necessary to review and investigate the background profile of the company before risking your amount in investment.
5. Return On Equity (ROE)
The last aim of any investor or trader is to achieve a significant investment return. The most important ratio is the ROE when things come to the company’s profitability, and it is calculated by dividing total income by shareholder’s equity. In simple terms, it tells how well a company rewards its shareholders for their assets.
ROE = Net Income/ Shareholder’s Equity
Generally, 15 to 20% ROE is considered good; the high-growth companies should have a more increased ROE. Investors can compare the profit value of the companies in the same sector. The general thumb rule always looks for a company with a higher ROE than 20%.
6. Dividend Yield
It is expressed in percentage by how much a company pays out in dividends each year according to its stock price. In other words, the amount of money a company pays to shareholders for owning a share of its stock to the current stock price.
Dividend Yield = Annual Dividends Per Share/ Price Per Share
It provides a clear estimation of how much traders can earn via dividends with investment in that company. If the dividend yield is higher, that doesn’t indicate an attractive investment opportunity. There may be another reason for rising the dividend yield due to falling stock prices.
7. Current Ratio
Get a clear idea about the company’s current working capital or liquidity. This ratio is estimated by dividing current assets by current liabilities.
Current Ratio = Current Assets/ Current Liabilities.
Usually, examine this ratio when short term investments are considered. It helps the traders to understand how conveniently companies can meet or cover their short-term liabilities or debt through current assets.
A company with less than 1 current ratio is vulnerable to buying its stock. If the value is more than one, the company has more assets than liabilities, so you can consider the company for investing.
Hard to analyze the fundamental aspects and impossible to compare with other companies with a long list of financial elements. The list of ratios helps the traders examine the enterprises’ financial status. Applying formulae or calculations in the investment game may slow down the process, although the ratios help you pick the right stocks for your portfolio.