Financial Ratios: The Basics and What They Show

Ratio. The phrase brings to mind challenging high school arithmetic problems. But it doesn't necessarily have to be the case when it comes to investing. In truth, there are some ratios that, when correctly used and understood, can help you become a more knowledgeable investor.

• Working Capital Ratio: It is important to measure the liquidity of a firm before investing in it. Liquidity is the ease with which a business can convert assets into cash to meet immediate obligations. You can use the working capital ratio to measure liquidity. A working capital ratio of 1 may indicate that a business may be experiencing liquidity issues and won't be able to cover its short-term obligations. However, the issue could just last a short while before getting better. A working capital ratio of at least 2 can signify sound liquidity and the capacity to cover short-term obligations. On the other hand, it may also be a sign that a company has too much short-term assets, such as cash, some of which would be better invested in the business or used to pay dividends to shareholders.
• Quick Ratio: The quick ratio, also known as the acid test, is another metric for liquidity. It shows a company's capacity to quickly convert liquid assets into cash to cover its short-term obligations. If the quick ratio is less than 1, there may not be enough liquid assets to cover current liabilities. The business might need to raise money or take other steps. On the other hand, it might only be a passing circumstance.
•  Earnings per Share (EPS): When you purchase a stock, you share in the company's potential earnings (or loss). Earnings per share (EPS) is a metric used to assess a company's profitability. It helps investors understand the value of the company. Earnings per share will be 0 or negative if a corporation has no earnings or negative earnings (i.e., a loss). Greater value is indicated by a higher EPS.
• Price-Earnings Ratio (P/E): Investors use this ratio, known as P/E for short, to assess a stock's growth potential. It displays how much they would fork out in exchange for $1 of earnings. It is frequently used to contrast the potential values of several stocks. The P/E ratio will be meaningless if a company has no earnings or losses. N/A, which stands for not applicable, will appear.
• Debt-to-Equity Ratio: What if the potential recipient of your investment has excessive debt? This may result in more fixed costs, lower earnings available for dividends, and risk for stockholders. Divide the total liabilities by the total shareholders' equity to get the debt-to-equity ratio. Consider that Company XYZ has $13.3 million in shareholders' equity and loans totaling $3.1 million. That results in a reasonable ratio of 0.23, which is acceptable in most cases.
• The metric must be examined in light of industry standards and company-specific criteria, just like any other ratios.
• Return on Equity (ROE): Return on equity (ROE) measures profitability and the efficiency with which a business generates profits from its shareholders. For common stockholders, ROE is computed by dividing total shareholders' equity by net income, which is defined as income less expenses and taxes, before paying common share dividends and after paying preferred share dividends.
• The Bottom Line: You may choose the best stocks for your portfolio and increase your wealth by using financial ratios. Fundamental analysis employs dozens of financial ratios. We have briefly discussed six of the most typical and straightforward to calculate. Keep in mind that one ratio alone cannot provide a reliable assessment of a company. To make more confident financial decisions, be sure to apply a range of ratios. If you like to start developing yourself in this field, check our Financial training programs