One key step in investing in stocks involves learning how to read and figure out the key financial ratios. You have to know what they mean and what they can tell you, even if you get ratio figures from your broker or a website. You could make mistakes without that knowledge, 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 the price-to-cash-flow ratio instead of the better-known price-to-earnings ratio. It's figured bydividing a company's market capitalization by its cash flow or by dividing its share price by its cash flow from operations per share.
The price-to-earnings ratio, or P/E, is likely the most famous ratio in the world. It's a quick and easy way to see how cheap or costly a stock is, compared to its peers.
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 decide 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. It may be a better clue than the simpler ratio based on price alone as to whether a stock is cheap or costly.
Asset Turnover Ratio
This ratio gauges the revenue generated by each dollar of assets a company owns. It's a good way of judging how well it has been using its assets, compared to its peers.
Like the price-to-earnings ratio, the current ratio is one of the most famous. It serves as a test of financial strength. It can give you an idea as to whether it a company has too much or too little cash on hand to meet its obligations. It's figured by dividing current assets by current liabilities.
The quick ratio is another way of helping you pinpoint a company's financial strength. It's also known as the "acid test." As the name suggests, it's a more stringent measure of its ability to meet its obligations. It subtracts inventory from current assets before dividing by current liabilities. The point is that a company may need a good deal of time to liquidate its assets before the money can be used to cover what it owes.
The debt-to-equity ratio lets you compare the total stockholders' equity of a company (the amount they 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 viewpoint of its owners.
Dividing a company's debt by this equity—and doing the same for others —can tell you how highly leveraged it is, compared to its peers.
Gross Profit Margin
The gross profit margin lets you know how much of a company's profit is available as a percentage of revenue to meet its expenses. Subtract the cost of goods sold from total sales. Divide the result by total sales.
Net Profit Margin
The net profit margin tells you how much money a company makes for every $1 it has in revenue. A company makes 14 cents in profit for every dollar of revenue if its net profit margin is 0.14.
Interest Coverage Ratio
The interest coverage ratio is vital for firms that carry a lot of debt. It lets you know how much money is there to cover the interest expense a company incurs on the money it owes each year.
Operating income is gross profit minus operating costs. It's the total pre-tax profit a business generated from its operations. It can also be described as the money that's available to the owners before a few items have to be paid, such as preferred stock dividends and income taxes.
The company's operating margin is its operating income divided by its revenue. It's a way of measuring a company's efficiency.
Accounts Receivable Turnover Ratio
The sooner a company's customers pay their bills, the sooner it can put that cash to use. The accounts receivable turnover ratio is a handy way to figure the number of times in a year a business collects on its accounts. You'll have the average number of days it takes it to get paid if you divide that number by 365.
Inventory Turnover Ratio
You can find how many times a firm turns its inventory over during a period of time by using this ratio. An extremely efficient retailer will have a higher inventory turnover ratio.
Return on Assets
Return on assets, or ROA, tells you how much profit a company generated for each dollar it has in assets. It's figured by dividing net profits by total assets. This figure indicates how well a company is using its assets to generate profit. It's most useful when a company's ROA is compared to those of its peers.
Return on Equity
One key metric is return on equity, or ROE. It reveals how much profit a company earned, compared to the total amount of stockholders' equity found on its balance sheet.
Advanced Return on Equity: The DuPont Model
The DuPont model, or DuPont analysis, lets you to break down return on equity to determine what's driving ROE. It can also give you vital information about a company's capital structure.
Working Capital Per Dollar of Sales
The working capital per dollar of sales ratio lets you know how much money a company has on hand to conduct business. The more working capital a company needs, the less valuable it is. That's money that the owners can't take out in the form of dividends.
Frequently Asked Questions (FAQs)
What are financial ratios?
A financial ratio can be any ratio that gives owners and potential investors insight into an entity's financial performance. They're important, because they allow for more accurate comparisons between companies. Owners can use financial ratios to target areas that need improvement, and investors can use them to help choose between investments.