Financial Ratios

Financial ratios allow an analyst to quickly analyze a business and its operations and understand the financial situation of a company. These ratios answer many different kinds of questions that can be asked about a business performance. Normally, many of these ratios need to be understood in the context of a benchmark, such as, past historical norm, or industry standards.

We will outline some of the key financial ratios classified according to the aspect of the business they describe. Further detailed information can be had by visiting the pages each of these terms link to. So without further ado, let’s get to the list of financial ratios every investor needs to know.

Key Financial Ratios for Valuation

  • Price to Earnings (P/E): A measure of how the stock is priced in the market relative to the earnings per share
  • Price to Book Value (P/B): A measure of how the stock is priced in the market relative to the book value per share
  • Dividend Yield: Describes the dividend an investor will receive as a percentage of the price paid for the stock
  • Dividend Payout Ratio: Amount of earnings or net income the company pays out as dividends to the shareholders. The company needs to keep a part of earnings for its operations and future growth. A very high dividend payout ratio could be unsustainable.
  • Enterprise Value/EBIT (EV/EBIT): This is a similar ratio to P/E but considers the full capital structure of the business (Enterprise Value = Equity + Debt – Cash). Describes the multiple an acquirer will expect to pay to acquire the entire business.
  • PEG Ratio: P/E ratio normalized for growth rates. Adjusts for the fact that high growth companies may command a greater P/E ratio in the market.

Key Financial Ratios for Profitability

  • Return on Equity: Profitability of the company as a percent of shareholder’s equity
  • Return on Assets: Profitability of the company as a percent of total assets
  • Earnings per Share (EPS): Annual earnings of the company expressed as a per common share value
  • Profit Margin: Amount of profit a company makes for every unit of sales

Key Financial Ratios for Liquidity

  • Current Ratio: Describes the coverage current assets of the company provide for the current liabilities
  • Quick Ratio (Acid Test): Same as Current Ratio but does not include inventory in the current assets since inventory can be hard to quickly convert to liquid cash when needed
  • Interest Coverage: The ability of the company to pay interest on its debts out of Earnings Before Interest and Taxes (EBIT). This ratio is an indicator of the solvency of the company

Key Financial Ratios for Business Activity

  • Inventory Turnover: How many times does the company sell or replace its inventory in a given period. Faster moving inventory is a good sign for companies where the inventory depreciates fast.
  • Average Collection Period: How long does the company take on average to collect its receivables? A larger number indicates the company is extending long term credit to its buyers and will need a larger working capital to back up this gap

Key Financial Ratios for Leverage

  • Debt Ratio: Proportion of company’s assets that is financed by debt.
  • Debt to Equity Ratio: The amount of debt leverage used by the company vis a vis the equity in the capital structure