Ratios monitor business performance. They can evaluate and contrast several businesses that you could think about investing in. It need not be the case that the word “ratio” brings up difficult and stressful high school arithmetic problems. When ratios are properly applied and understood, they can aid in your becoming a more knowledgeable investor.
KEY TAKEAWAYS
- To calculate various ratios used in fundamental analysis, data from business financial statements is used.
- A security’s intrinsic or actual worth is ascertained via fundamental analysis so that the market value of the security can be contrasted with it.
- Six fundamental ratios are frequently employed to choose equities for investing portfolios.
- The working capital ratio, the quick ratio, the price-earnings ratio, the debt-to-equity ratio, and the return on equity ratio are all examples of ratios.
- For a complete picture of a company’s financial health, it is usually preferable to use multiple ratios rather than just one.
1. Working Capital Ratio
It is important to measure the liquidity of a firm before investing in it. Liquidity describes how quickly a business may convert assets into cash to meet short-term obligations. You can use the working capital ratio to measure liquidity. It shows how well a business can use its current assets to cover its current liabilities.
Current Assets – Current Liabilities = Working Capital. Working capital is the difference between a company’s current assets and current liabilities.
Similar to working capital, the working capital ratio calculates liquidity by contrasting current assets and liabilities. By dividing current assets by current liabilities, one can determine the working capital ratio: current assets / current liabilities = working capital ratio.
Consider that XYZ Company has $8 million in current assets and $4 million in current liabilities. By dividing $8 million by $4 million, the working capital ratio is 2. This is a sign of sound short-term liquidity. But what if two comparable businesses each had a ratio of two? The company that has more cash on hand among its present assets would be able to settle its debts faster than the other.
A working capital ratio of one may indicate that a business may be experiencing liquidity issues and won’t be able to cover its short-term obligations. But the issue might only last a short while before getting better.
A working capital ratio of two or above can suggest sound liquidity and the capacity to meet short-term obligations, but it can also signal an excessive amount of short-term assets, such as cash, for a company. Some of these resources might be better put to use as corporate investments or dividend payments to shareholders.
2. Quick Ratio
The acid test is another name for the quick ratio. It is an additional metric for liquidity. It shows a company’s capacity to quickly transform liquid assets into cash to cover its short-term obligations.
Current Assets – Inventory Prepaid Expenses / Current Liabilities (current Assets minus Inventory Prepaid Expenses divided by Current Liabilities) is the formula for calculating the quick ratio. Because it can take time to sell goods and turn it into liquid assets, the formula eliminates it.
The XYZ Company has $4 million in current obligations, $2 million in inventory, and $8 million in current assets. It also has $2 million in prepaid expenses. With $8 million minus $2 million divided by $4 million, the quick ratio is 1.5. It means that the business has enough cash on hand to cover its expenses and carry on with operations.
If the quick ratio is less than 1, there may not be enough liquid assets to cover current liabilities. The business might need to raise money or take other steps. On the other hand, it might only be a passing circumstance.
3. Earnings Per Share (EPS)
When you purchase stock, you share in the company’s potential future profits or loss. Earnings per share (EPS) is a metric used to assess a company’s profitability. It helps investors understand the value of the company.
Earnings per share (EPS) is calculated by the company’s analysts by dividing net income by the weighted average number of outstanding common shares for the year: net income / weighted average = EPS. If a corporation has zero earnings or negative earnings, which signify a loss, earnings per share will likewise be zero or negative. Greater value is indicated by a higher EPS.
4. Price-Earnings Ratio (P/E)
Investors use this ratio, known as P/E for short, to assess a stock’s growth potential. It displays how much they would fork out in exchange for $1 of earnings. It is frequently used to contrast the potential values of several stocks.
Divide the current stock price of a firm by its earnings-per-share to arrive at the P/E ratio: current stock price / earning- per-share = price-earnings ratio.
If a business closed trading at $46.51 per share and its EPS for the previous 12 months was $4.90 on average, its P/E ratio would be 9.49 ($46.51 / $4.90). For every dollar of annual earnings produced, investors would spend $9.49. When they believed that future earnings growth would provide them with acceptable returns on their investments, investors have been willing to pay more than 20 times the EPS for some equities.
If a corporation has no earnings or a loss, the P/E ratio is no longer valid. The letter N/A will stand in for “not applicable.”
5. Debt-to-Equity Ratio
What if the potential recipient of your investment has excessive debt? This may result in more fixed costs, lower earnings available for dividends, and risk for stockholders.
The debt-to-equity (D/E) ratio calculates how much borrowed money a company is using to fund its operations. If necessary, it can show whether shareholder equity is sufficient to pay off all debts. Investors frequently use it to contrast the leverage employed by various businesses in the same sector. They can use this information to decide which investment would be lower risk.
To determine the debt-to-equity ratio, divide the total liabilities by the total shareholders’ equity:total liabilities / total shareholders’ equity = debt-to-equity ratio.
Consider that Company XYZ has $13.3 million in shareholders’ equity, $3.1 million in loans, and no debt. That results in a reasonable ratio of 0.23, which is acceptable in most cases. However, the ratio must be examined in light of sector standards and business-specific needs, just like all other ratios.
6. Return on Equity (ROE)
Return on equity (ROE) measures profitability and the efficiency with which a business generates profits from its shareholders. ROE is calculated as a proportion of shareholders of common stock.
It is determined by dividing net income, or revenue less expenses and taxes, by the sum of the dividends paid on common and preferred shares. Subtract the outcome from the 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 imagine the net income for XYZ corporation is $1.3 million. Equity held by shareholders totals $8 million. Therefore, ROE is 16.25%. The corporation is better at generating profits from shareholder equity the higher the ROE.
Types of Ratio Analysis
Based on the sets of data they give, the numerous financial ratios that are available can be broadly categorised into the following six silos:
- Liquidity Ratios:-Liquidity ratios assess a company’s capacity to pay down short-term loans when they come due, utilising current or fast assets. The current ratio, quick ratio, and working capital ratio are all liquidity ratios.
- Solvency Ratios:-Solvency ratios, also known as financial leverage ratios, compare a firm’s debt levels to its assets, equity, and earnings to assess the chances of a company staying afloat in the long run by paying off its long-term debt as well as the interest on its debt. Debt-equity ratios, debt-assets ratios, and interest coverage ratios are all examples of solvency ratios.
- Profitability Ratios:-These ratios indicate how well a company’s activities can create profits. Profitability ratios include profit margin, return on assets, return on equity, return on capital utilised, and gross margin ratios.
- .Efficiency Ratios:-Efficiency ratios, often known as activity ratios, assess how effectively a corporation uses its assets and liabilities to create sales and maximise profits. The following efficiency ratios are important: turnover ratio, inventory turnover, and days’ sales in inventory.
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