The Most Important Financial Ratios for New Investors
Before you start investing in individual stocks, a key step is learning how to interpret and calculate the most important financial ratios. Even if you usually get financial ratio figures from your broker or a financial website, you still ought to know what they represent and what they can tell you about a business in which you're considering investing. Otherwise, you could make a mistake such as buying into a company with too much debt or paying too much for a stock with meager earnings growth potential.
Some investors prefer to focus on a financial ratio known as the price-to-cash-flow ratio instead of the more well-known price-to-earnings ratio. It's calculated by dividing a company's market capitalization by its cash flow from operations or dividing its share price by its cash flow from operations per share.
The price-to-earnings ratio, or P/E, is probably the most famous financial ratio in the world. It's a quick and easy way to determine how cheap or expensive the stock is compared with its peers.
The simplest definition of the P/E is the amount of money the market is willing to pay for every $1 in earnings a company generates. You have to consider whether that amount is too high, a bargain, or somewhere in between.
The PEG ratio goes one step further than the P/E. It factors in the projected rate of earnings growth for a company and may be a better indicator of whether a stock is cheap or expensive than the simpler ratio based on price alone.
The asset turnover ratio calculates the revenue generated by each dollar of assets a company owns. It's a good way of comparing how efficiently a company has been using its assets in relation to its peers.
Like the price-to-earnings ratio, the current ratio is one of the most famous of all the financial ratios. It serves as a test of a company's financial strength and can give you an idea of whether a company has too much or too little cash on hand to meet its obligations. It's calculated by dividing current assets by current liabilities.
The quick ratio is another way of helping you determine a company's financial strength. It's also known as the acid test and, as the name suggests, is a more stringent measure of a company's ability to meet its obligations. It subtracts out inventory from current assets before dividing by current liabilities because a company may need a good deal of time to liquidate its inventory before the money can be used to cover liabilities.
The debt-to-equity ratio enables investors to compare the total stockholders' equity of a company (the amount stockholders have invested in the company plus retained earnings) to its total liabilities. Stockholders' equity is sometimes viewed as the net worth of a company from the perspective of its owners. Dividing a company's debt by its stockholders' equity—and doing the same for the company's competitors—can tell you how highly leveraged a company is in comparison with its peers.
The net profit margin tells you how much money a company makes for every $1 in revenue. For example, if a company's net profit margin is 0.14, the company makes 14 cents in profit for every dollar of revenue.
The interest coverage ratio is an important financial ratio for firms that carry a lot of debt. It lets you know how much money is available to cover the interest expense a company incurs on the money it owes each year.
Operating income—gross profit minus operating expenses—is the total pre-tax profit a business generated from its operations. It can also be described as the money available to the owners before a few items need to be paid, such as preferred stock dividends and income taxes. The company's operating margin is its operating income divided by its revenue and is a way of measuring a company's efficiency.
The sooner a company's customers pay their bills, the sooner the company can put that cash to use. The accounts receivable turnover ratio is a handy method of calculating the number of times in a year a business collects its accounts receivable. If you divide that number into 365, you'll have the average number of days a company takes to get paid.
You can calculate how many times a business turns its inventory over during a period of time by using the inventory turnover ratio. An extremely efficient retailer will have a higher inventory turnover ratio than a less efficient competitor.
Return on assets, or ROA, tells an investor how much profit a company generated for each dollar in assets. This ratio, which is calculated by dividing net profits by total assets, measures how efficiently a company's management is utilizing its physical assets to generate profit and is most useful when comparing a company's ROA to that of its peers.
The working capital per dollar of sales financial ratio is important because it lets you know how much money a company needs to keep on hand to conduct business. Generally speaking, the more working capital a company needs, the less valuable it is because that's money the owners can't take out of the business in the form of dividends.