- Financial ratios are the most important factor on the balance sheet of any company.
What are financial ratios, and why are they useful?
- Financial ratios are derived from the balance sheet of the company, which also represents important information.
- They are used to do the fundamental analysis of the company.
- They are also used to simplify the most complicated things.
- There are a lot of factors that are present on the balance sheet of the company.
- It is impossible to analyze all of these factors and compare them with the others.
- Instead of this, a trader should simply compare 2 companies by using financial ratios to get a better investment opportunity.
Some of the important financial ratios are as follows:
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1. Price to Earnings Ratio (PE Ratio)
- This is the most widely used financial ratio.
- It is defined as the current share price divided by the earnings per share.
- In short, it is nothing but how many rupees you will be able to invest in that company to earn 1 rupee.
- In mathematical terms, P/E = share price/earnings per share.
- A high PE ratio will indicate that the traders are expecting high earnings growth from the company in the near future.
- A lower PE ratio will indicate that the company is undervalued.
- In general, if you are looking for a value stock, then a low PE ratio will be preferred.
- However, every sector will have different PE ratios.
- You cannot compare the metal sector stock PE with the IT sector PE, as this is totally an illogical comparison.
2. Earnings per Share (EPS)
- This is the most basic financial ratio.
- It is defined as the profit of the company per outstanding share.
It is calculated in 2 ways
1. Earnings per share: net income after tax/total number of outstanding shares
2. Weighted earnings per share: (net income after tax – total dividends) / total number of outstanding shares.
- Higher EPS will indicate that the return on a single share is high.
- From the trader’s point of view, it is always a good idea to invest in a company that has a higher and growing EPS.
- Before investing in any company for the long term, you should always check the EPS of the company for the last 5 years.
- If it is continuously growing, then it is a good company to invest in; otherwise, you can search for better options.
3. Price to Book Value Ratio (PBV)
- This ratio will give the relation between the current value of the company and its book value.
- Book value is the value of all the assets owned by the company.
- PBV ratio = market capitalization/book value.
- This ratio will help the investors to recognize the undervalued companies.
- Generally, a PB ratio below 1 will indicate an undervalued company, but a PB less than 1 will also indicate that there are some other problems with the company because of which it is showing proper earnings.
- So, traders should look at the parameters of the company as well.
- Also, many traders and financial analysts consider any value under 3 as a good PBV ratio.
4. Debt to Equity Ratio
- This ratio is also called a risk ratio, and it is used to calculate total debt and liabilities against the equity of the shareholders.
- If this ratio is less than 1, then your investment in that company is less risky than the company with a high debt-to-equity ratio.
- A company that has a debt-to-equity ratio of more than 1 is using more leverage to run its business operations.
- Thus, the risk is greater there, and one should review their investments before investing in such types of companies.
5. Return on Equity (ROE)
- This is the most important ratio when it comes to the profitability of the company.
- It is calculated by dividing the net income by the shareholder's equity.
- In mathematical terms, ROE = net income/shareholders equity.
- If ROE is higher, it will represent that the company is earning more profits from its operations.
- In this way, ROE is one of the parameters that will determine the profitability of the company.
- The thumb rule here states to always look for companies that have an ROE higher than 20%.
6. Dividend Yield
- The dividend yield of the stock can be calculated by dividing the company’s annual cash dividend per year by the current price of the share.
- It is represented in a percentage.
- This ratio will estimate how much a trader can make through the dividends by investing in that company.
- Dividend yield = annual dividend per share / current share price.
7. Current Ratio
- This ratio is calculated to get an idea about the liquidity or the current working capital of the company.
- This ratio is obtained by dividing the current assets by the current liabilities.
- Current ratio = current assets // current liabilities.
- This ratio will also show how to prepare the company to meet its short-term obligations with the short-term assets.
- A current ratio that is less than 1 can be considered to be a bad current ratio.
Conclusion
These are the financial ratios that every beginner should know before investing in any particular company.
Frequently Asked Questions
Q1) Which financial ratio is the most important among all the ratios?
The return on equity ratio is the most important among all the ratios.
Q2) Which PE ratio is good?
A PEPE ratio below 20 is good.
Q3) How to remember financial ratios?
Group all the similar ratios together based on their purposes.
Q4) What is a good dividend yield?
A ratio of 2 or more is a good dividend yield.
Q5) What is the P&L ratio formula?
It is the average profit on winning trades divided by the average loss on losing trades over a specified time period.
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