Financial Ratio Analysis | Investment Series

What is Financial Ratio

Financial ratio analysis is a group of ratios that are used to evaluate a business's financial condition, performance and position.

Ratios identify strengths and weaknesses in a company’s performance, enable comparisons with other companies, provide important insights into financial stability, facilitate planning as well as projections.

Financial ratios are used to determine a company's financial health and financial status.

They are typically presented as a comparison of one value to another, such as assets to liabilities or equity to debt.

Why We need Financial Ratio

If you want to know whether your financial standing is in good order, you need to look into the following financial ratio.

These financial ratio will you a guideline of what you need to improve for your financial health.

Financial ratios are important to analyze because they help you to monitor a company's performance, solve problems and provide information about the direction in which the company is heading.

Financial ratios provide additional information about a company’s ability to generate profit with minimal equity.

Financial ratios are used to measure the ability of a company or its subsidiary to pay off its financial obligations and remain profitable.

Each ratio reflects a fundamental aspect of the company's performance.

1. Liquidity Ratio

Liquidity Ratio is used to measure the ability of the company to meet its short-term financial obligations.

It measures a company’s ability to pay their short-term liabilities.

Liquidity Ratio should be less than 1 and greater than zero.

It indicates the number of months in which living expenses can be paid if emergency arises; a high liquidity ratio is desirable.

The ratio also determines the ability of a company to pay dividends, thus indicating how safe investment will be on those stocks.

Liquidity Ratio = Liquid Asset / Monthly Expenses.

2. Earning per Share

Earnings per Share (EPS) is a measure of the profitability of a company's equity.

It is calculated by dividing the net income attributable to shareholders by the average number of shares outstanding.

EPS provides an indication as to how much each share in a company contributes to its profits, and can be used as an indicator for whether investors should invest in that company or not.

Investors utilize it to obtain an understanding of corporate value.

If a corporation has zero or negative profits (i.e., a loss), then earnings per share will likewise be 0 or negative. A higher EPS suggests better value.

3. Price-Earnings Ratio (P/E)

Called P/E for short, this ratio is used by investors to estimate a stock's potential for growth. It represents how much someone would spend to get $1 of earnings.

It's typically used to compare the prospective worth of a selection of equities.

To calculate the P/E ratio, divide a company's current stock price by earnings-per-share.

If, for example, a business finished trading at $46.51 a share and the EPS for the preceding 12 months was $4.90, then the P/E ratio would be 9.49 ($46.51/$4.90).

Investors would spend $9.49 for every created dollar of yearly profits.

Investors have been ready to pay more than 20 times the EPS for particular equities when they've judged that a future expansion in profits would offer them a satisfactory return on their investment.

If a corporation has zero or negative profits, the P/E ratio will no longer make sense. It will display as N/A if not applicable.

When ratios are correctly understood and implemented, they may assist enhance your investment performance.

4. Debt-to-Equity Ratio

What if your desired investment target is borrowing too much?

This may raise fixed costs, diminish profits available for dividends, and represent a risk to shareholders.

The debt-to-equity (D/E) ratio shows how much a firm is supporting its operations with borrowed money.

It may show if shareholder equity can pay all debts, if required.

Investors typically use it to analyse the leverage utilised by various firms in the same sector.

This may allow them to assess which could be a lesser risk investment.

To determine the debt-to-equity ratio, divide total liabilities by total shareholders' equity.

Let's assume business XYZ has $3.1 million worth of debt and shareholders' equity of $13.3 million. 

That comes out to a small ratio of 0.23, which is acceptable under most circumstances.

However, like all other ratios, the statistic needs to be assessed in context of industry standards and company-specific criteria.

5. Return on Equity (ROE) (ROE)

Return on equity (ROE) evaluates profitability and how well a firm utilises shareholder money to produce a profit.

For common stock shareholders, ROE (which is represented as a percentage) is computed by taking net income (income minus costs and taxes) estimated before paying common share dividends and after paying preferred share dividends, and dividing the result by total shareholders' equity.

Let's suppose XYZ company's net income is $1.3 million. Its stakeholder equity is $8 million.

ROE then is 16.25%. The greater the ROE, the better the firm is at creating profits utilizing shareholder equity.

What's a Good ROE?

Return-on-equity, or ROE, is a statistic used to assess investment returns.

It's a measure of how successfully a corporation leverages shareholder equity to create profits.

You can consider a good ROE one that improves consistently over time.

That might imply a corporation performs a good job leveraging shareholder cash to boost earnings.

In turn, it may improve shareholder value.

What Is Fundamental Analysis?

Fundamental analysis is the investigation of a security to identify its actual (or inherent) value.

It includes the study of economic, industrial, and corporate information.

Fundamental analysis may be valuable because by comparing an asset's real worth to its market value, an investor can decide whether the investment is appropriately priced, overvalued, or undervalued.

Fundamental analysis differs with technical analysis, which focuses on determining price movement and employs other tools, such as chart patterns and price trends, to accomplish so.

Is a Higher or Lower P/E Ratio Better?

That depends on what you're looking for in an investment.

A P/E ratio gauges the relationship of a stock's price to earnings per share.

A lower P/E ratio might signal that a company is inexpensive and potentially worth purchasing.

However, it might be low since the firm isn't financially strong.

A greater P/E might signal that a stock is costly, but it could be because the firm is performing well and could continue to do so.

Often, the greatest approach to utilize P/E is as a relative value comparison tool for companies you're interested in.

Or, you might want to compare the P/E of one or more stocks to an industry average.

In Conclusion

Financial ratios can help you choose the finest stocks for your portfolio and develop your wealth.

Dozens of financial ratios are employed in basic analysis.

We've quickly selected five of the most popular and simplest to compute.

Happy Investing! 😉