Top Financial Ratios Every Investor Should Know

Conducting fundamental analysis is important for investors before picking stocks. In the process, investors study a company’s financial records to determine if its stock is worth investing in. To help them have a quick look at the financial health and status of companies, financial ratios are obtained. Financial ratios help investors interpret the company’s balance sheet and income statements more effectively, and base their decision on the same.

These stock analysis ratios help in assessing the performance, liquidity, profitability, and operational efficiency of an organisation. Also, some investors use them to compare companies to check for potential investment opportunities. The five key financial ratios that everyone must know of have been discussed below!

Top 5 Important Financial Ratios to Know When Investing

If you are a seasoned investor or just a beginner, learning about key ratios is essential to analyse the financials of an organisation. 

Using these ratios, you can compare the companies with their closest competitors. You can also get insights, and know the performance of the company and how it evolved. The following are the important financial ratios that everyone should know about.

• Earnings Per Share (EPS)

Buying a stock not only means participating in the future earnings of a company, but it also indicates involvement in the unprecedented risk of loss. Earnings per share is one of the important financial ratios that helps measure the profitability of an organisation. 

It tells you how much profit an enterprise makes for each outstanding share of stock. EPS is calculated by dividing net income by the weighted average number of shares outstanding.

Earnings per share = Net income / Total outstanding shares 

The EPS value is not always positive. It can also be zero or negative when a company does not earn or when there is negative income, showing a loss. 

Remember, a higher EPS indicates a greater value. But it is vital to know its limits as well. Top executives have much control over various accounting practices, which may impact net income and earnings per share. So, you should know how earnings are calculated and not just consider EPS at face value.

• Price/Earning Ratio (P/E)

Another important financial ratio is the P/E ratio used by investors to determine a stock’s potential for growth. It is calculated as the ratio of the current stock price of a company and its earnings per share.

Price/Earning ratio = Current stock price/Earning per share

Profit-making companies with average or below-average growth potential are likely to trade at lower P/E ratios than those expected to grow at higher rates. Moreover, notable investor Warren Buffett made a fortune by purchasing shares in companies with high growth prospects but trading at low P/E ratios.

For a thriving business, check for a forward P/E ratio (projected earnings per share) as it may be more useful than using historical earnings, which is likely to misguide you with an elevated ratio. However, forecasting does not guarantee success as many stocks from fast-growing businesses suffered a downfall when they failed to materialise. 

Further, the P/E ratio can also be modified to calculate an earnings yield. To calculate, take earnings per share and divide it by the stock price. This gives investors a parameter to compare the yield with other investment opportunities.

• Return on Equity (ROE)

Return on Equity is another important financial ratio to measure profitability and how efficiently businesses use shareholder funds to make profits. It measures how good a company is at rewarding its shareholders for the funds it makes. It is calculated as the ratio of the net income to the total shareholder’s equity. Return on

equity = Net income/Total shareholder’s equity

For example, there are two companies. Each earned one crore rupees in 2004. While one company invested 10 crores to generate those earnings, the other only invested five crores. This shows how well the second company used the shareholders’ capital and recorded a better-performing business that year.

Moreover, generally, a higher return on equity is considered better. However, the desire for high returns is likely to attract multiple companies that look forward to capitalising on this profitability, which increases the overall competition. More competition always proves negative for a business, driving once-high returns on equity down to a more normal level. 

• Debt-to-Equity (D/E) Ratio

For any investor, knowing profitability is as important as understanding business finance and whether the business is in a position to handle the debt it has. What if your prospective investment is taking too much debt? In that case, you might face increased fixed charges, and fewer earnings for dividend distribution, posing a risk to shareholders. 

The debt-to-equity ratio measures the debt an organisation takes to support its operations. It can indicate whether shareholder equity can cover all the debts when needed. D/E is used to compare different companies operating in the same industry, helping to determine which might be a lower-risk investment. To calculate the debt-to-equity ratio, divide total liabilities by total shareholder’s equity.

Debt-to-equity ratio = Total liabilities/Total shareholder’s equity

A higher ratio indicates that the company is indebted. Generally, businesses with a debt-to-equity ratio above 40% warrant a closer look from the investors to make sure the company can handle the debt load.

• Quick Ratio

Another important financial ratio is the quick ratio, also known as the acid test ratio. It checks how capable a business is of meeting its short-term financial obligations through its liquid assets or by using assets that can be converted into cash.  

Quick ratio is useful to analyse if a business is facing any financial difficulties during economic downturns or other events when profit figures are tough to reach. Subtract the inventory from current assets and then divide the result by current liabilities.

Quick ratio = Current assets – Inventory- prepaid expenses / Current liabilities

The formula excludes inventory because it can take time to sell them off and convert them into liquid assets. In addition, an acid test ratio of 1 or less indicates that a company may need to raise additional funds from investors or have to wait to see any improvement in its business promptly.

Conclusion

Financial ratios help investors choose the right stock at the right time. All the above ratios are vital and should be looked at in totality, rather than just focusing on one or two ratios. This ensures they understand a company’s financial position before they pick the stocks to build your wealth. 

Want to make smarter stock investments? Connect with the experts at Torus Digital and get guidance on picking the top stocks.