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Analyzing a company’s financial ratios is one way of examining a company’s balance sheet and income statement. Financial ratios track a company’s performance, liquidity, operational efficiency, and profitability. Some investors use ratios to compare companies and select between potential investment opportunities.
There are many different ratios that analysts and investors can use to analyze and make predictions about a company’s financial performance and potential future growth. The six basic financial ratios are: the working capital ratio, the quick ratio, earnings per share (EPS), price-to-earnings (P/E), debt-to-equity (D/E), and return on equity (ROE). Read on to learn more about these financial ratios.
Key Takeaways
- Analyzing a company’s financial ratios is one way of examining a company’s balance sheet and income statement.
- Financial ratios track a company’s performance, liquidity, operational efficiency, and profitability.
- There are six basic financial ratios that are often used to pick stocks for investment portfolios: the working capital ratio, the quick ratio, earnings per share (EPS), price-to-earnings (P/E), debt-to-equity (D/E), and return on equity (ROE).
- Most ratios are best used in combination with others rather than singly to get a comprehensive picture of a company’s financial health.
Working Capital Ratio
Assessing the health of a company involves measuring its liquidity. Liquidity refers to how easily a company can turn assets into cash to pay its short-term obligations. The working capital ratio can help you measure liquidity. It’s a measure of a company’s ability to pay its current liabilities with its current assets.
Working capital is the difference between a firm’s current assets and current liabilities:
Current Assets – Current Liabilities = Working Capital
The working capital ratio, like working capital, compares current assets to current liabilities and is a metric used to measure liquidity. The working capital ratio is calculated by dividing current assets by current liabilities:
Current Assets / Current Liabilities = Working Capital Ratio
Suppose that Company XYZ has current assets of $8 million and current liabilities of $4 million. The working capital ratio is 2 ($8 million/$4 / $4 million = 2). That’s an indication of healthy short-term liquidity. But, what if two similar companies each had ratios of 2? The firm with more cash in its current assets could pay off its debts more quickly.
A working capital ratio of 1 can imply that a company may have liquidity troubles and be unable to pay its short-term liabilities. But the problem could be temporary and later improve.
A working capital ratio of 2 or higher can indicate healthy liquidity and the ability to pay short-term liabilities, but it could also point to a company that has too much in short-term assets, such as cash. Some of these assets might be better used to invest in the company or to pay shareholder dividends.
Quick Ratio
The quick ratio, also known as the acid test, is another measure of liquidity. It represents a company’s ability to pay current liabilities with assets that can be converted to cash quickly.
The calculation for the quick ratio is:
Current Assets – Inventory Prepaid Expenses / Current Liabilities
The formula removes inventory because it can take time to sell and convert inventory into liquid assets.
Suppose Company XYZ has $8 million in current assets, $2 million in inventory and prepaid expenses, and $4 million in current liabilities. That means the quick ratio is 1.5 ($8 million—$2 million/$4 / $4 million = 1.5). This indicates that the company has enough money to pay its bills and continue operating.
A quick ratio of less than 1 can indicate that there aren’t enough liquid assets to pay short-term liabilities. The company may have to raise capital or take other actions. On the other hand, it may be a temporary situation.
Earnings Per Share (EPS)
When buying a stock, you participate in the company’s future earnings and the risk of loss. Earnings per share (EPS) measure a company’s profitability. Investors use EPS to understand a company’s value.
EPS is calculated by dividing net income by the weighted average number of common shares outstanding during the year:
Net Income / Weighted Average = Earnings Per Share
Earnings per share will also be zero or negative if a company has zero earnings or negative earnings, representing a loss. A higher EPS indicates greater value.
Price-to-Earnings (P/E) Ratio
Investors use the price-to-earnings (P/E) ratio to determine a stock’s potential for growth. It reflects how much they would pay to receive $1 of earnings. It’s often used to compare the potential value of a selection of stocks.
To calculate the P/E ratio, divide a company’s current stock price by its earnings per share:
Current Stock Price/Earnings Per Share = Price-Earnings Ratio
A company’s P/E ratio would be 9.49 ($46.51 / $4.90 = 9.49) if it closed trading at $46.51 a share and the EPS for the past 12 months averaged $4.90. Investors would spend $9.49 for every generated dollar of annual earnings.
Investors have been willing to pay more than 20 times the EPS for certain stocks when they feel that future earnings growth would give them adequate returns on their investments.
The P/E ratio will no longer make sense if a company has zero or negative earnings. It will appear as N/A, which stands for “not applicable.”
Important
Ratios can help improve your investing results when they’re properly understood and applied.
Debt-to-Equity (D/E) Ratio
What if your prospective investment target is borrowing too much? This can increase fixed charges, reduce earnings available for dividends, and pose a risk to shareholders.
The debt-to-equity (D/E) ratio measures how much a company is funding its operations using borrowed money. It can indicate whether shareholder equity can cover all debts, if necessary. Investors often use it to compare the leverage used by different companies in the same industry. This can help them determine which might be a lower-risk investment.
Divide total liabilities by total shareholders’ equity to calculate the debt-to-equity ratio:
Total Liabilities / Total Shareholders’ Equity = Debt-to-Equity Ratio
Suppose Company XYZ has $3.1 million in loans and $13.3 million in shareholders’ equity. That works out to a modest ratio of 0.23, which is acceptable under most circumstances.
However, like all other ratios, the metric must be analyzed in terms of industry norms and company-specific requirements.
Return on Equity (ROE)
Return on equity (ROE) measures profitability and how effectively a company uses shareholders’ money to make a profit. ROE is expressed as a percentage of common-stock shareholders.
It’s calculated by taking net income (income less expenses and taxes) figured before paying common-share dividends and after paying preferred-share dividends. Divide the result by total shareholders’ equity:
Net Income (Expenses and Taxes Before Paying Common Share Dividends and After Paying Preferred Share Dividends) / Total Shareholders’ Equity = Return on Equity
Suppose Company XYZ’s net income is $1.3 million. Its shareholder equity is $8 million. The company’s ROE is 16.25%. The higher the ROE, the better the company is at generating profits using shareholder equity.
What Is a Good Return on Equity (ROE)?
Return on equity (ROE) is a metric used to analyze investment returns. It’s a measure of how effectively a company uses shareholder equity to generate income. You might consider a good ROE to be one that increases steadily over time. This could indicate that a company does a good job using shareholder funds to increase profits. That can, in turn, increase shareholder value.
What Is Fundamental Analysis?
Fundamental analysis is an investment or security analysis to discover its true or intrinsic value. It involves the study of economic, industry, and company information.
Fundamental analysis is useful because it can help an investor determine whether the security is fairly priced, overvalued, or undervalued by comparing its actual value to its market value.
Fundamental analysis contrasts with technical analysis, which focuses on determining price action and uses different tools, such as chart patterns and price trends.
Is a Higher or Lower P/E Ratio Better?
It depends on what you’re looking for in an investment. A price-to-earnings (P/E) ratio measures the relationship of a stock’s price to earnings per share. A lower P/E ratio can indicate that a stock is undervalued and perhaps worth buying, but it could be low because the company isn’t financially healthy. A higher P/E ratio can indicate that a stock is expensive, but that could be because the company is doing well and could continue to do so.
The best way to use P/E is often as a relative value comparison tool for stocks you’re interested in. Or, you might want to compare the P/E of one or more stocks to an industry average.
The Bottom Line
Financial ratios can help you pick the best stocks for your portfolio and build your wealth. Dozens of financial ratios are used in fundamental analysis. This article highlights six of the most common financial ratios.
Remember that a company cannot be properly evaluated using just one ratio in isolation. Be sure to use a variety of ratios for more confident investment decision-making.
