Top Stories | Sat, 14 Dec 2024 06:05 PM

Top 10 Financial Ratios Every Investor Should Know

Posted by : SHALINI SHARMA

The importance of financial ratios varies in assessing the ability of a given organization to perform, its stability, and overall health in business. It tells the investors how effectively the business operates and serves as an indicator of possible investment.

Financial ratios support a company concerning its profitability ratios, liquidity ratios, and ultimately the company's overall financial health. Investors involve understanding the ratios so that they can better inform their decisions and appraisals on whether a company is a proper fit for their investment portfolio. From the seasoned investor to the slightly inquisitive, these ratios represent the most critical tools to use in evaluating and effectively managing potential investments.

1. Price to earnings (P/E) ratio: 

Price fairs to Earn-it Metric is really one of the highly perceived metrics upon setting the price on a company stock about whether its price is over-or-under-stated.

The formula: P/E = Price per Share / Earnings per Share (EPS)

What this indicates: The ratio between price and earnings refers to paying much or too little towards income coming from investments in the company revenue statements. Value added for high quotes may mean hyped prices while value added for low quotes is taken to imply undervalued putting. 

Why it matters: It plays an important role in evaluating stocks in universities. An investor can check if it commands a proper price against its earning capacity. Higher could refer to high hopes for future growth while lower may be due to low hopes for future growth.

2. Price-to-Book (P/B) Ratio:

So, the Price-to-Book (P/B) ratio is a very good measure of the relationship between the market value and book value of an asset. It shows you just how much investors are paying for the net assets of a company.

Formula: P/B = Price per Share / Book Value per Share

What this indicates: The ratio tells you how much an investor is spending for every dollar of net asset. For example, if the P/B is less than 1, it could be assumed that the stock is undervalued.

Why it matters: This is especially applicable for those industries where tangible assets are significantly high, like Manufacturing, Real Estate, etc.

3. Debt-to-Equity (D/E) Ratio:

The Debt-to-Equity (D/E) ratio measures financial leverage for a company, showing how much, it owes compared to what the shareholders are contributing.

Formula: D/E = Total Debt / Shareholders Equity

What this indicates:

Most of the time, a very high D/E ratio indicates that there is a company dependent on debts for financing and that risk is greater. In low ratios, meaning, lesser amounts are associated with debt funding in comparison.

Why it matters: 

Investors would be worried if the company had a very high D/E ratio since the company might not be able to survive in times of economic downturn. Lesser debt levels are usually seen as a less risky proposition.

4. Current Ratio: 

Current assets relative to current liabilities, this ratio defines the ability of a company to fulfill its short-term liabilities with short term assets.

Formula: Current Ratio = Current Assets / Current Liabilities.

What this indicates: This ratio is like obtaining short-term liquidity status in the company. A ratio greater than 1 indicates that the company has sufficient assets to cover its current liabilities.

Why it matters: It measures an important part of financial health. With a ratio below 1, it may indicate liquidity problems; a higher one means that the company is rather well positioned to liquidate short-term debt obligations.

5. Return on Equity (ROE):

ROE is the measure of a company's profitability, with regard to generating profits with the shareholders' equity.

Formula: ROE = Net Income / Shareholder Equity

What this indicates: It shows how much efficiently equity is being used in generating profit by a company. The higher the value of ROE better is the management performance.

Why it matters: It is a primary measure of a management's ability to return on investment to the shareholders. Investors prefer companies that show high and steady ROE.

6. Return on Asset: 

Return on Assets (ROA) is the efficiency with which a company impoverishes its assets for generating profit.

Formula: ROA = Net Income/Total Assets

What this indicates: A high ROA indicates that a company uses its assets efficiently in producing income, which is preferably significant for asset-heavy industries such as manufacturing.

Why it matters: It is ROA that enlightens an investor on how effectively a company manages its assets. The higher the ROA, the better assets the company uses to increase its profitability.

7. Operating Margin:

Operating Margin is that particular profitability ratio showing the ratio of company's revenues that remains after paying its variable costs, such as wages and raw materials.

Formula: Operating income/Revenue

What this indicates: This ratio tells how efficiently the core operations of this company are managed. On a higher operating margin, this would imply that the company retains more from its sales.

Why it matters: This represents the profit that a company makes on its sales before interest and taxes are deducted from it. It is often believed that a higher operating margin would be indicative of a competitive advantage.

8. Quick Ratio (Acid-Test Ratio):

The Quick Ratio is a more conservative measure of a company’s liquidity than the current ratio. It excludes inventory, which may not be as liquid.

Formula: Quick Ratio = (Current Assets - Inventory) / Current Liabilities

What this indicates: It shows a company’s ability to meet its short-term obligations with its most liquid assets. A ratio above 1 is generally considered safe.

Why it matters: The quick ratio is important for assessing a company’s ability to survive in times of financial stress, especially when it may struggle to sell inventory.

9. EBITDA Margin: 

It gives an insight into how much profit a company makes by its operations before considering non-operating costs such as interest, taxes, and the depreciation of assets.

Formula: EBITDA Margin = EBITDA / Revenue 

What this indicates: This is the ratio which shows how much cash is generated from the operations of a company and serves as an indicative parameter for measuring its operational efficiency.

Why it matters: A higher EBITDA margin indicates that the company has been able to effectively convert its sales into profits, which is one of the important aspects for judging the overall financial health of that company.

10. Dividend Yield:

In Financial terms, Dividend Yield is the measure, which reflects how much cash flows an Investor is receiving with respect to the stock price received as dividends.

Formula: Dividend Yield = Annual Dividends per Share / Price per Share

What this indicates: Income from dividend earnings for an investor can be measured due to dividend yield. The higher the dividend yield, the more interesting it would be for most kinds of investors with income focus. 

Why it matters: Potentially attractive to an income investor, the dividend yield signals an interest in companies with reliable dividend distributions. An excessively high yield can also denote a danger that the company may not meet its debt obligations due to an unsustainably high payout ratio.