5 Basic Financial Ratios Every Investor Should Know
Understanding a company’s financial health is key to make smart investment decisions. Knowing the basic financial ratios is one of the best ways to achieve this.
Assessing a company’s financial ratios give you insights into various aspects of a business from its profitability to its debt and liquidity. In this article, we will go through 5 basic financial ratios every investor should know to invest with confidence.
1. Price-to-Earnings Ratio (P/E Ratio)
The Price-to-Earnings (P/E) ratio is one of the most popular financial ratios in investment analysis. It’s the price you pay for $1 of earnings.
Why It’s Important
- Valuation Indicator: A high P/E may mean the stock is overpriced or investors expect high growth. A low P/E may mean undervalued or limited growth.
- Comparative Analysis: Investors use P/E to compare companies in the same industry.
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Growth Expectations: P/E ratio can reflect market’s expectation of future earnings growth. For example a tech startup with new products might have high P/E ratio due to rapid growth.
How to Calculate
P/E Ratio = Market Price per Share / Earnings per Share
Example
A company’s stock is trading at $50 and EPS is $5. The P/E ratio would be 10. So, investors are paying $10 for every $1 of earnings.
2. Debt-to-Equity Ratio (D/E Ratio)
The Debt-to-Equity (D/E) ratio measures a company’s financial leverage by comparing total liabilities to shareholders’ equity. It shows how much debt a company is using to finance its assets relative to the value of shareholders’ equity.
Why It Matters
- Risk Assessment: A high D/E ratio means the company is highly leveraged and may be at risk during economic downturns.
- Financial Stability: A lower D/E ratio means the company is more conservative in its financing and may be more stable.
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Long-term Solvency: Companies with high D/E ratio might struggle to get further financing without higher costs.
How to Calculate
D/E Ratio = Total Liabilities / Shareholders’ Equity
Example
$200,000 in total liabilities and $400,000 in shareholders’ equity means a D/E ratio of 0.5. That’s $0.50 of debt for every $1 of equity.
3. Current Ratio
The Current Ratio is a liquidity ratio that measures a company’s ability to pay its short-term debts with its short-term assets. It’s a key indicator of short-term financial health.
Why It Matters
- Liquidity Measure: A higher current ratio means the company has enough assets to cover its short-term liabilities, good liquidity.
- Operational Efficiency: It shows how well the company is managing its working capital.
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Creditworthiness: Lenders and creditors look at current ratio to see if a company can pay short term debt.
Current Ratio = Current Assets / Current Liabilities
Example
$150,000 in current assets and $100,000 in current liabilities means a current ratio of 1.5. That’s $1.50 of assets for every $1 of liabilities.
4. Return on Equity (ROE)
ROE measures a company’s profitability by showing how much profit it generates with the money shareholders have invested. It’s a key indicator of management’s use of equity capital.
Why It Matters
- Profitability Measure: Higher ROE means better use of equity capital.
- Investment Comparison: Investors use ROE to compare profitability across companies in the same industry.
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Management Performance: ROE shows how well management is using equity to grow the company and make profits.
How to Calculate
ROE = (Net Income / Shareholders’ Equity) × 100
Example
$50,000 net income and $500,000 shareholders’ equity means an ROE of 10%. That’s 10% return on shareholders’ equity.
5. Earnings per Share (EPS)
Earnings per Share (EPS) measures the portion of a company’s profit allocated to each outstanding share of common stock. It’s a key indicator of profitability on a per-share basis.
Why It Matters
- Profitability Indicator: Higher EPS means more profitable and often a sign of good financial health.
- Valuation Tool: EPS is used in calculating the P/E ratio, which is a key valuation metric.
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Investor Confidence: A consistently increasing EPS suggests the company is growing and generating more profits for its shareholders.
How to Calculate
EPS = (Net Income − Dividends on Preferred Stock) / Average Outstanding Shares
Example
$100,000 net income, $10,000 preferred dividends and 90,000 outstanding shares means EPS of $1. That’s $1 per share.
Bottom Line
Financial ratios are the tools for investors to see how a company performs, risks and profitability. By understanding and analyzing P/E, D/E, current ratio, ROE and EPS, you can make better decisions and assess potential investments.
Understanding these basic financial ratios will help you to evaluate companies better, and build a stronger and more profitable portfolio.
Related Topics
If you’re interested in improving your financial analysis knowledge further, check out our articles on “Financial Statements: Overview of the Three Financial Statements” and “Ratio Analysis: Types, Definition and Formula“.
These resources will provide you additional insights to understand the basic financial ratios.
