Fundamental analysis of stocks requires understanding various aspects of the company and its valuation. Financial ratios allow an analyst to quickly analyze a company 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.
Why Use Financial Ratios?
At the heart of it, all companies are similar. Every company exists to produce and sell a product or service. It has to organize itself in ways to make this process optimum and at the same time treats its stakeholders fairly in a way that further expansion of the business is possible. This allows us to compare different companies in an industry (or even across industries) on some key indicators and judge whether a company is performing better than or worse than the average. Ratio analysis can help us quickly make judgement on the strength of a company's operations and financial condition.
Can you do the same analysis without using financial ratios? Perhaps, but it will be more complex and will not improve the accuracy of judgement to any significant degree. It is a good idea to start with the ratios first, and then as necessary dig deeper into other aspects of the business to enhance our understanding beyond what the ratios can tell us.
The 17 Key Ratios for Stock and Company Analysis
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 Valuation Ratios
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. This is a balance sheet ratio.
- Dividend Yield: Describes the cash 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 Profitability Ratios
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. This can be net, operating or gross.
Key Liquidity Ratios
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
Learn more: stock trading basics
Key Business Activity Ratios
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 Leverage Ratios
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.
- 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
Ratio Analysis – How to Use a Financial Ratio to Analyze a Stock?
A financial ratio does not exist in a vacuum. It is best used for company analysis by comparing across multiple competitors, or by analyzing the trend over time. Often you have to do both to gain different insights. Consider for example, debt. The value of debt by itself does not make much sense without context. We can ask multiple questions:
- Is the debt too little or too much for the company to handle? You can answer this question by looking at the debt/equity ratio or debt/capital ratio. You can also look at the interest coverage ratio to see if the company is able to handle the interest payments on the debt without struggle.
- Is the company over-relying on debt compared to the competitors? You will have to compare the debt/equity ratio with competitors in the industry. Some industries are naturally debt heavy as they are very capital intensive. For example, most industrials. Others, such as Information Technology, can be very debt light. If a company has debt load that varies significantly than what the competitors in the same industry have, you will need to question why.
- Is the company improving its debt position? You will have to compare the debt/equity ratio over time to see if it has been coming down (if it was too high earlier). Alternatively, since debt is a cheaper way to finance a company, you may want to see a company increasing their debt/equity ratio if it was too low earlier.
You can do a similar exercise with any other financial ratio you are looking at. This type of horizontal and vertical ratio analysis helps greatly in understanding financial trends and benchmarks, and can help you find issues in accounting or other red flags too. Any unexplained change, financial or otherwise, in the trend needs to have a reason.
Use this list of key financial ratios to understand any company 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.