Financial ratios are the best tools to conduct financial analysis and performance of a company. By using financial ratios, you will be able to pick the best companies to invest in, measure their profitability, liquidity, efficiency and financial risk.
In this article you will learn about the top 11 financial ratios that you can use to pick companies to invest in.
I believe that you are reading this article because you want to gain new knowledge and/or become a better investor. I must say you are in the right place and you will not be disappointed. Read until the end and become wiser!
There are many financial ratios that are used in the equity investing world. This article will only cover the essential ones which are the Gross Profit Margin, Net Profit Margin, Current Ratio, Quick Ratio, Dividend Payout ratio, Price/Earnings ratio, Earnings Per Share, Dividend Yield, Debt/Equity ratio, Return on Equity, and Price/Book ratio.
Without further delay, let’s dive deep into the financial ratios.
1. Gross Profit Margin
The gross profit margin shows the variability of sales (or revenue) over time. Gross profit is sales less cost of goods sold. The gross profit margin shows the percentage of revenue left after removing cost of goods sold.
Formula:
Gross Profit Margin = Gross Profit/Revenue
For example, XYZ has $800 in gross profit and $1000 in revenue. The gross profit margin will be:
Gross Profit Margin = $800/$1000, we get 80%. This ratio shows that 20% of the revenue was consumed by cost of goods sold.
The higher the gross profit margin ratio the better.
2. Net Profit Margin
The Net profit margin ratio shows how much a business has made in profit after deducting all expenses. In fact, it shows how much revenue is left after removing all expenses. This ratio is very important to investors as no investor would want to invest money in a company that is not profitable. Net profit increases the wealth of shareholders.
To calculate this ratio, we need to extract the revenue figure (or top line) and net income (or bottom line) from the company’s income statement.
The formula for calculating the net profit margin is as follows:
Net profit margin = Net profit/Revenue
For example, a company has $500 in net profit and $1000 in revenue. The net profit margin will be:
Net profit margin = $500/$1000, we get 50%.
The higher the net profit margin the better.
3. Current Ratio
The current ratio measures the liquidity of a business. It tells us whether the company has enough current assets to cover current liabilities.
Formula:
Current Ratio = Current Assets/Current Liabilities
For example, a company has current assets of $500 and current liabilities of $300. The current ratio will be:
Current Ratio = $500/$300, we get 1.67. This essentially means that the company has $1.67 of current assets to cover $1 of current liabilities.
4. Quick Ratio
The quick ratio is also known as the acid test ratio. This ratio compares liquid current assets less inventory to current liabilities. It tells us whether or not current assets will cover current liabilities if we remove inventory.
Formula:
Quick Ratio = (Current assets – Inventory)/Current liabilities
For example, a company has $400 in current assets after removing inventory and $300 in current liabilities. The quick ratio will be:
Quick Ratio = $400/$300, we get 1.33
5. Dividend Payout Ratio
The Dividend Payout Ratio is used to assess different dividend paying stocks. It shows how much shareholders have received in dividends over a certain period of time.
Formula:
Dividend Payout Ratio = Dividends Paid/Net Income
For example, a company paid $250 in dividends in 2021 and had a net income of $500. The dividend payout ratio will be:
Dividend Payout Ratio = $250/$500, we get 50%.
6. Dividend Yield
The Dividend Yield ratio is used to analyze and compare different dividend paying stocks.
Dividends are payments made to shareholders out of profits. A company can only pay dividends when it has made some profit from its operations. Not all companies pay dividends. This depends on which stage the company is on the business life cycle.
Here is an example of how you can profit from dividends;
A company’s board of directors may decide to distribute $2 per each share held and suppose you hold 1000 shares in the company you will receive $2000 in dividends.
To calculate the Divided Yield ratio, you need to extract the amount of dividend paid from the cash flow statement under financing activities section and divide it by the number of common shares outstanding to get dividend per share. Or sometimes, it may be easy to find either in investor presentation documents or the company’s annual report.
Let’s say XYZ has declared an annual dividend per share of $2 and the share price is $6.
Let’s calculate Dividend Yield:
Dividend Yield = Dividend Per Share/Share Price
Dividend Yield is measured in percentages (%)
Dividend Yield = $2/$6, we get 33%.
7. Earnings Per Share
The EPS ratio shows the net income that a company’s common stock has generated over the past one year. The EPS ratio is used to measure profitability potential of a company.
Earnings denote net income (net profit or the bottom line). You can extract it from the company’s income statement.
When calculating the EPS ratio, the number of common stock outstanding is used and preferred shares are excluded.
You can find the number of common stock outstanding on the investor relations section of the company’s website.
Below is the formula for calculating EPS:
EPS = Net income/Average Common Stock Outstanding
For example, XYZ a company in the retail sector has generated $100 in net earnings and has outstanding common stock of 20. In this case, the EPS is 5.
8. Price Earnings Ratio
The PE ratio is the most popular and widely used ratio in the world of investing. It tells us how much the market is willing to pay for each $1 of the company’s earnings.
To calculate the PE ratio, we use the market capitalization and net earnings.
Market capitalization is the value of the asset or entire business as determined by the market. That is why it is also called the market value of equity. Terms such as market cap, and market price (or price) are also used to denote market capitalization.
Market cap is calculated as follows:
Market capitalization = share price (or price per share) x number of outstanding ordinary shares
There are two ways to calculate the PE ratio:
1st Formula
PE = Market capitalization / Net earnings
2nd Formula
PE = Share price/EPS
Let’s assume, the share price of XYZ is $0.50, $100 in net earnings and the number of common shares is 20. Let’s calculate the PE ratio using the first formula:
First, we need to calculate the market cap.
Market Cap = $0.50 x 20, we get $10.
Now, let’s calculate the PE ratio:
PE = $10/$100, we get a PE ratio of 0.1.
Let’s calculate the PE ratio using the second method and the EPS we have calculated above;
PE = $0.50/5, we get 0.1. Either way you will get same results.
9. Debt/Equity Ratio
The Debt/Equity ratio is a capital structure ratio. It tells us how much debt capital has been used to fund the business compared to equity capital. Simply put, the ratio tells us about the financing mix of a company.
When a business uses debt as part of its financing mix, it is called financial leverage (or leverage). A lowly leveraged business uses less debt and more of equity whereas a highly leveraged business uses more of debt than equity.
To calculate the Debt/Equity ratio, we extract the book value of debt (total debt) and the book value of equity from the company’s balance sheet.
Let’s look at an example,
Let’s assume, XYZ has total debt of $100 and shareholders’ equity of $200. Let’s calculate the Debt/Equity Ratio.
Formula:
Debt/Equity ratio = Total Debt/Total Shareholders’ Equity
Debt/Equity ratio is measured in percentage (%)
Let’s calculate the Debt/Equity ratio:
Debt/Equity Ratio = $100/$200, we get 50%.
The lower the D/E ratio the better.
10. Return on Equity
This is the most important ratio for the equity investor. Every investor requires above average returns on their investments. This ratio shows whether or not management is doing a great job to create wealth for the shareholders. It also shows how efficiently management uses invested equity funds to generate profit.
To calculate ROE, we extract net income from the company’s income statement and shareholders’ equity from the balance sheet.
Formula:
ROE = Net income/Average Total Shareholders’ Equity
ROE is measured in percentage (%)
Let’s say XYZ has made a net profit of $1000 and has $2500 in shareholders’ equity in its balance sheet.
Let’s calculate ROE:
ROE = $1000/$2500, we get 40%
The rule of thumb for this ratio is that the higher the better.
11. Price/Book Ratio
The P/B ratio is used to compare a company’s market value to its book value.
Market Capitalization is the same as market value or market value of equity.
Market value of equity is the value of an asset or entire business as determined by the market or investor. Market cap is current.
Market value of equity can be calculated as share price x the number of outstanding ordinary shares.
Book value of equity is the value of an asset or entire business as determined by its financials or books. Book value of equity is historic.
Book value of equity can be extracted from the company’s balance sheet. Simply put, the book value of equity is the total shareholders’ equity.
Below is the formula for calculating the P/B ratio:
P/B Ratio = Market Capitalisation/Book value
A P/B ratio of less than 1 may indicate that the market price is less than the book value.
Conclusion
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