The Most Important Financial Ratios for New Investors
Before you start investing in individual stocks, it is very useful to learn how to understand, calculate, and interpret financial ratios. Even if you usually get financial ratios from your broker or a financial site, you still need to know what they represent and what they can tell you about the business in which you would like to invest. Otherwise, you could make a mistake such as buying into a company with too much debt, not enough cash to survive, or low profitability. This guide to financial ratios will explain how to calculate the most important financial ratios, and, more importantly, what they mean.
You can't calculate financial ratios without using a company's financial statements. This guide to financial statements provides step-by-step instructions on how to read a balance sheet, income statement, and other important accounting documents.
All financial ratios fall into one of five categories. By learning about each of these five categories, you'll know which financial ratio calculations to use when you want to start assessing and analyzing potential investment targets.
You'll also learn which ratios are calculated to analyze the balance sheet, which ratios are used to interpret the income statement, and which ratios can help you assess a company's peers and its industry.
Some investors prefer to focus on a financial ratio known as the "price to cash flow ratio" instead of the more famous "price-to-earnings ratio" (or p/e ratio for short). Sit back, relax, and grab a cup of coffee because you're about to learn everything you ever wanted to know about this often overlooked stock valuation tool.
The price to earnings ratio, also known as the p/e ratio, is probably the most famous financial ratio in the world. It is used as a quick and dirty way to determine how "cheap" or "expensive" the stock is. The best way to think of it is how much you are willing to pay for every $1 in earnings a company generates. Learn how to calculate it, and much more.
While the price to earnings ratio (or p/e ratio for short) is the most popular way to measure the relative valuation of two stocks, the PEG ratio goes one step further. It stands for the price-to-earnings-to-growth ratio. As you can tell by its title, the PEG ratio factors in a company's growth.
The asset turnover financial ratio calculates the total sales generated by each dollar of assets a company owns. In other words, it measures how efficiently a company has been using its assets.
Like the price to earnings ratio, the current ratio is one of the most famous of all financial ratios. It serves as a test of a company's financial strength and relative efficiency. For instance, you can tell if a company has too much, or too little, cash on hand.
The debt to equity ratio is important because investors like to compare the total equity (net worth) of a company to its debt obligations. For instance, if you own $100 million worth of hotels and have $30 million in debt, you are going to be less concerned than if you have the same $30 million in debt with only $40 million worth of real estate. Learn how to calculate the debt to equity ratio and why it is important.
The gross profit margin lets you know how much profit is available as a percentage of sales to pay payroll costs, advertising, sales expenses, office bills, etc. It's one of the most important financial ratios you can learn.
The interest coverage ratio is an important financial ratio for firms that use a lot of debt. It lets you know how much money is available to cover all of the interest expense a company incurs on the money it owes each year.
If you need to know how many times a business turns its inventory over a period of time, you'll need to use the inventory turnover ratio. It allows you to see if a company has too many of its assets tied up in inventory and is heading for financial trouble. An extremely efficient retailer, for instance, is going to have a higher inventory turnover ratio than a less efficient competitor.
The net profit margin ratio tells you how much money a company makes for every $1 in revenue. Companies with higher net profit margins can often offer better benefits, heftier bonuses, and fatter dividends.
Operating income, or operating profit as it is sometimes called, is the total pre-tax profit a business generated from its operations. It is what is available to the owners before a few other items need to be paid such as preferred stock dividends and income taxes.
The Quick Test Ratio (also called the Acid Test or Liquidity Ratio) is the most excessive and difficult test of a company's financial strength and liquidity.
When you are analyzing a business or a stock, common sense tells you that the faster a company collects its accounts receivables, the better. The sooner customers pay their bills, the sooner a company can put the cash in the bank, pay down debt, or start making new products. There is also a smaller chance of losing money to delinquent accounts. Fortunately, there is a way to calculate the number of days it takes for a business to collect its receivables - it's called receivable turns or receivable turnover, and it's a useful financial ratio to learn.
Where asset turnover tells an investor the total sales for each $1 of assets, return on assets, or ROA, tells an investor how much profit a company generated for each $1 in assets. The return on assets figure is also a sure-fire way to gauge the asset intensity of a business. For example, does the company in which you are researching have to spend large sums of money on expensive machinery before it can manufacture and sell a product to generate a return? It is one of the most important financial ratios you can know.
One of the most important profitability metrics is a return on equity (or ROE for short). Return on equity reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet.
Once you know how to calculate the return on equity financial ratio mentioned above, you need to go even further and break it down into the various components. This is called the DuPont analysis. By learning it, you can actually see what it is that makes a company profitable. It is, and remains, the secret to understanding most great fortunes.
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.