6 Basic Financial Ratios and What They Reveal (2024)

Ratios track company performance. They can rate and compare one company against another that you might be considering investing in. The term "ratio" conjures up complex and frustrating high school math problems, but that need not be the case. Ratios can help make you a more informed investor when they're properly understood and applied.

Key Takeaways

  • Fundamental analysis relies on data from corporate financial statements to compute various ratios.
  • Fundamental analysis is used to determine a security's intrinsic or true value so it can be compared with the security's market value.
  • There are six basic ratios that are often used to pick stocks for investment portfolios.
  • Ratios include the working capital ratio, the quick ratio, earnings per share (EPS), price-earnings (P/E), debt-to-equity, and return on equity (ROE).
  • Most ratios are best used in combination with others rather than singly to accomplish a comprehensive picture of a company's financial health.

1. Working Capital Ratio

Assessing the health of a company in which you want to invest involves measuring its liquidity. The term liquidity refers to how easily a company can turn assets into cash to pay short-term obligations. The working capital ratio can be useful in helping you measure liquidity. It represents a company'sability to payits current liabilities with its current assets.

Working capitalis the difference between a firm’s current assets and current liabilities: current assets - current liabilities = working capital.

The working capital ratio, like working capital, compares current assets to current liabilities and is a metric used to measure liquidity. The working capital ratio is calculated by dividing current assets by current liabilities: current assets / current liabilities = working capital ratio.

Let's say that XYZ company has current assets of $8 million and current liabilities of $4 million. The working capital ratio is 2 ($8 million / $4 million). That's an indication of healthy short-term liquidity. But what if two similar companies each had ratios of 2? The firm with more cash among its current assets would be able to pay off its debts more quickly than the other.

A working capital ratio of 1 can imply that a company may have liquidity troubles and not be able to pay its short-term liabilities. But the trouble could be temporary and later improve.

A working capital ratio of 2 or higher can indicate healthy liquidity and the ability to pay short-term liabilities, but it could also point to a company that has too much in short-term assets such as cash. Some of these assets might be better used to invest in the company or to pay shareholder dividends.

It can be a challenge to determine the proper category for the vast array of assets and liabilities on a corporatebalance sheetto decipher the overall ability of a firm to meet its short-term commitments.

2. Quick Ratio

The quick ratio is also called the acid test. It's another measure of liquidity. It represents a company's ability to pay current liabilities with assets that can be converted to cash quickly.

The calculation for the quick ratio is current assets - inventory prepaid expenses / current liabilities (current assets minus inventory minus prepaid expenses divided by current liabilities). The formula removes inventory because it can take time to sell and convert inventory into liquid assets.

XYZ company has $8 million in current assets, $2 million in inventory and prepaid expenses, and $4 million in current liabilities. That means the quick ratio is 1.5 ($8 million - $2 million / $4 million). It indicates that the company has enough to money to pay its bills and continue operating.

A quick ratio of less than 1 can indicate that there aren't enough liquid assets to pay short-term liabilities. The company may have to raise capital or take other actions. On the other hand, it may be a temporary situation.

3. Earnings Per Share (EPS)

When buying a stock, you participate in the future earnings or the risk of loss of the company. Earnings per share (EPS) is a measure of the profitability of a company. Investors use it to gain an understanding of company value.

The company's analysts calculate EPS by dividing net income by the weighted average number of common shares outstanding during the year: net income / weighted average = earnings per share. Earnings per share will also be zero or negative if a company has zero earnings or negative earnings representing a loss. A higher EPS indicates greater value.

4. Price-Earnings Ratio (P/E)

Called P/E for short, this ratio is used by investors to determine a stock's potential for growth. It reflects how much they would pay to receive $1 of earnings. It's often used to compare the potential value of a selection of stocks.

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

A company's P/E ratio would be 9.49 ($46.51 / $4.90) if it closed trading at $46.51 a share and the EPS for the past 12 months averaged $4.90. Investors would spend $9.49 for every generated dollar of annual earnings. Investors have been willing to pay more than 20 times the EPS for certain stocks when they've felt that a future growth in earnings would give them adequate returns on their investments.

The P/E ratio will no longer make sense if a company has zero or negative earnings. It will appear as N/A for "not applicable."

Ratios can help improve your investing results when they're properly understood and applied.

5. Debt-to-Equity Ratio

What if your prospective investment target is borrowing too much? This can increase fixed charges, reduce earnings available for dividends, and pose a risk to shareholders.

The debt-to-equity (D/E) ratio measures how much a company is funding its operations using borrowed money. It can indicate whether shareholder equity can cover all debts, if necessary. Investors often use it to compare the leverage used by different companies in the same industry. This can help them to determine which might be a lower-risk investment.

Divide total liabilities by total shareholders' equity to calculate the debt-to-equity ratio: total liabilities / total shareholders' equity = debt-to-equity ratio. Let's say that company XYZ has $3.1 million worth of loans and shareholders' equity of $13.3 million. That works out to a modest ratio of 0.23, which is acceptable under most circ*mstances. But like all other ratios, the metric must be analyzed in terms of industry norms and company-specific requirements.

6. Return on Equity(ROE)

Return on equity (ROE) measures profitability and how effectively a company uses shareholder money to make a profit. ROE is expressed as a percentage of common stock shareholders.

It's calculated by taking net income (income less expenses and taxes) figured before paying common share dividends and after paying preferred share dividends. Divide the result by total shareholders' equity: net income (expenses and taxes before paying common share dividends and after paying preferred share dividends) / total shareholders' equity = return on equity.

Let's say XYZ company's net income is $1.3 million. Its shareholder equity is $8 million. ROE is therefore 16.25%. The higher the ROE, the better the company is at generating profits using shareholder equity.

What's a Good ROE?

Return-on-equity or ROE is a metric used to analyze investment returns. It's a measure of how effectively a company uses shareholder equity to generate income. You might consider a good ROE to be one that increases steadily over time. This could indicate that a company does a good job using shareholder funds to increase profits. That can in turn increase shareholder value.

What Is Fundamental Analysis?

Fundamental analysis is the analysis of an investment or security to discover its true or intrinsic value. It involves the study of economic, industry, and company information. Fundamental analysis can be useful because an investor can determine if the security is fairly priced, overvalued, or undervalued by comparing its true value to its market value.

Fundamental analysis contrasts with technical analysis, which focuses on determining price action and uses different tools to do so, such as chart patterns and price trends.

Is a Higher or Lower P/E Ratio Better?

It depends on what you're looking for in an investment. A P/E ratio measures the relationship of a stock's price to earnings per share. A lower P/E ratio can indicate that a stock is undervalued and perhaps worth buying, but it could be low because the company isn't financially healthy.

A higher P/E can indicate that a stock is expensive, but that could be because the company is doing well and could continue to do so.

The best way to use P/E is often as a relative value comparison tool for stocks you're interested in, or you might want to compare the P/E of one or more stocks to an industry average.

The Bottom Line

Financial ratios can help you pick the best stocks for your portfolio and build your wealth. Dozens of financial ratios are used in fundamental analysis. We've briefly highlighted six of the most common and the easiest to calculate.

Remember that a company cannot be properly evaluated using just one ratio in isolation. Be sure to put a variety of ratios to use for more confident investment decision-making.

6 Basic Financial Ratios and What They Reveal (2024)

FAQs

What are the 6 financial ratios that analyze financial statements? ›

Financial ratio analysis is often broken into six different types: profitability, solvency, liquidity, turnover, coverage, and market prospects ratios. Other non-financial metrics may be scattered across various departments and industries.

What are the 6 fundamental ratios? ›

There are six basic ratios that are often used to pick stocks for investment portfolios. Ratios include the working capital ratio, the quick ratio, earnings per share (EPS), price-earnings (P/E), debt-to-equity, and return on equity (ROE).

What are the 6 components of a financial analysis? ›

FASB (Financial Accounting Standards Board) lists six qualitative characteristics that determine the quality of financial information: Relevance, Faithful Representation, Comparability, Verifiability, Timeliness, and Understandability.

What are financial ratios and what do they do? ›

Ratios measure the relationship between two or more components of financial statements. They are used most effectively when results over several periods are compared. This allows you to follow your company's performance over time and uncover signs of trouble.

What are 5 most important ratios in financial analysis? ›

5 Essential Financial Ratios for Every Business. The common financial ratios every business should track are 1) liquidity ratios 2) leverage ratios 3)efficiency ratio 4) profitability ratios and 5) market value ratios.

How to interpret ratio analysis? ›

Financial Ratio Analysis and Interpretation

When it comes to debt, a company is financially stronger when there is less debt and more assets. Thus a ratio less than one is stronger than a ratio of 5. However, it may be strategically advantageous to take on debt during growth periods as long as it is controlled.

What are the key financial ratios? ›

7 important financial ratios
  • Quick ratio.
  • Debt to equity ratio.
  • Working capital ratio.
  • Price to earnings ratio.
  • Earnings per share.
  • Return on equity ratio.
  • Profit margin.
  • The bottom line.

What are the types of financial ratios? ›

What are the four types of financial ratios?
  • Liquidity ratios.
  • Activity ratios (also called efficiency ratios)
  • Profitability ratios.
  • Leverage ratios.

What are the 6 components of a successful financial plan for a business? ›

A business financial plan typically has six parts: sales forecasting, expense outlay, a statement of financial position, a cash flow projection, a break-even analysis and an operations plan. A good financial plan helps you manage cash flow and accounts for months when revenue might be lower than expected.

What are the basic financial analysis? ›

Financial analysis is the process of evaluating businesses, projects, budgets, and other finance-related transactions to determine their performance and suitability. Typically, financial analysis is used to analyze whether an entity is stable, solvent, liquid, or profitable enough to warrant a monetary investment.

How to analyse financial ratios? ›

The four key financial ratios used to analyse efficiency are:
  1. Inventory-turnover ratio = sales divided by inventory.
  2. Days-sales outstanding = accounts receivable divided by average sales per day.
  3. Fixed-assets-turnover ratio = sales divided by net fixed assets.
  4. Total-assets-turnover ratio = sales divided by total assets.

What do gearing ratios show? ›

The gearing ratio is an indicator of the financial risk associated with a company. If a company has too much debt, it has the potential to fall into financial distress. Remember: A high gearing ratio shows a high proportion of debt to equity, while a low gearing ratio shows the opposite.

Are financial ratios important? ›

Financial ratios can be used to monitor a company's performance over time. This can help companies identify trends and make adjustments to their business strategy. 4. Financial ratios can help companies identify areas where they are overperforming or under-performing.

What are turnover ratios? ›

A turnover ratio in business is a measurement of the firm's efficiency. It is calculated by dividing annual income by annual liability. It can be applied to the cost of inventory or any other business cost. Unlike in investing, a high turnover ratio in business is almost always a good sign.

What are the ratios in financial statements? ›

There are five basic financial statement ratios that we can use to see how well a company is performing. They are the current ratio, the quick ratio, earnings per share, debt-to-assets ratio, and the return on equity. The first ratio is called the current ratio, or the working capital ratio.

What are the 5 financial statement analysis? ›

What are the five methods of financial statement analysis? There are five commonplace approaches to financial statement analysis: horizontal analysis, vertical analysis, ratio analysis, trend analysis and cost-volume profit analysis. Each technique allows the building of a more detailed and nuanced financial profile.

What is financial statement analysis using financial ratios? ›

Financial statement analysis involves techniques to compare financial data and to evaluate the position of a company. These techniques include ratio analysis, common-size analysis, comparisons across companies, trend analysis, and year-to-year analysis. It is important to mention that ratios vary between industries.

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