Fundamental analysis of stocks requires understanding various aspects of the business and vaulation. 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. Included in this financial ratios list are 17 ratios used as indicators for valuation, profitability, liquidity, business activity and leverage. 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. Some of these are stock ratios that illuminate the valuation aspect of the stock, while other ratios speak directly to the various business indicators. So without further ado, let's get to the list of financial ratios every investor needs to know.
Key Financial Ratios for Valuation
As investors, we are mostly interested in business valuation ratios. The following ratios provide indicators to tell us if the stock market is valuing the stock fairly. The judgement of fair valuation depends on the typical valuations for similar companies in similar industries. Many factors come into play and often times these ratios can get out of the typical range due to certain atypical business or industry conditions. Investors should take these ratios as merely indicators of value, not the final arbiter of value.
- Price to Earnings Ratio (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
Profitability ratios let us take a deeper look into the attractiveness of the business from a business owner's perspective. They answer the question: as a business owner, am I earning adequate return on my various assets? Am I able to generate profits efficiently?
- 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
Here we talk about the operational flexibility in the business. Share liquidity is a separate concept. Liquidity ratios answer questions about the ability of the company to meet its day to day obligations.
- 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
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Key Financial Ratios for Business Activity
The operating efficiency of a company is indicated by the business activity ratios. This includes measures of product movement as well as the cash to cash cycle.
- 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
Great companies make judicous use of debt or leverage. Leverage ratios indicate the strength of the capital structure and the available collateral. Debt financing is economically cheaper than equity but it ties up company assets as collateral.
So there you have it. Use this list of key financial ratios to understand any business or stock you are analyzing. These ratios are best to help you value a company as an investor and you use them as you need. These can be part of your stock selection checklist. But be aware that to find the best stock picks, you need to have a more rounded understanding of the stock market then just knowing these ratios. There are limitations of financial ratios that can lead you astray if you are not careful. You will find it useful to spend some time and learn the stock market concepts.