5 Must-Check Financial Ratios For Company Analysis
Created on 21 Oct 2023
Wraps up in 6 Min
Read by 1.8k people
Updated on 02 Dec 2023
In the realm of investing, every listed company, fund, security, and bond is subjected to rigorous financial scrutiny. From calculating profit margins to unearthing hidden debts, every aspect is meticulously examined to determine if it has the potential to be a wise investment.
This intricate process involves calculating several ratios and financial parameters, each serving as a vital puzzle piece. Today, we embark on a journey to uncover five essential financial ratios that every investor should keep in their arsenal. ⚔️
Whether you are an experienced investor or a newbie just beginning your investment journey, you must have heard about these ratios. Hence, you must be wondering what’s so unique about this article, right? Well, the thing is, I won’t be only mentioning the ratios along with their definitions and formulas.
I will also include one unique factor for the ratios discussed, similar to power punches, knocking off your prejudices and helping you eliminate common investing mistakes.
Therefore, open your portfolio on one screen and keep scrolling this article on the other. And yes! Don't forget to grab your pen and notebook because Insider's class is about to begin. 🤓
1. Earnings Per Share (EPS) Ratio
Earnings Per Share is a Profitability Ratio that indicates how much profit a company generates for each common outstanding stock. It is calculated by dividing a company's net income (which is the capital left after expenses are paid) by the total number of outstanding common shares.
In simple words, it helps measure the earning capacity of a company. A higher EPS denotes more earnings per share for shareholders, which are either reinvested or distributed as dividends.
Unique Aspect of EPS
One unique aspect of EPS is that it provides a per-share perspective of a company's profitability. Hence, it allows individual investors with both small and large holdings of shares to assess the company's earnings. The higher the EPS, the better the financial condition of the company and more profits would be available to be distributed to shareholders.
Analysing EPS is important in all industries, but it is essential when profitability, growth, and stable earnings are used to judge a company's health.
Hence, when it comes to EPS, even the smallest investors can dream big! After all, good things come in small packages, right? 😉
Learn how it helps make investing easier by going through the article What is Earnings Per Share?
2. Return on Equity (ROE)
Return on Equity is a financial ratio that measures a company's profitability and is often used to assess how effectively a company generates returns for its shareholders' equity.
In simple terms, ROE describes how effective a company is in providing returns to its shareholders' investments.
Distinctive Factor of ROE
ROE clearly and directly measures how efficiently a company generates profits from shareholders' equity. It serves as a vital measure of the company's performance in terms of creating value for its equity investors. If measured correctly, then ROE can help you receive "Really Outstanding Earnings!" 🤗
Coming back, review the article Return on Equity: Definition & Examples to learn more interesting aspects of ROE.
3. Price to Earnings (P/E) Ratio
The Price-to-Earnings ratio is a fundamental indicator that provides insight into how much investors are willing to pay for each rupee of a company's earnings. The P/E ratio is calculated by dividing the current market price per share (the price at which a company's stock is trading) by its Earnings Per Share (which we just discussed).
Plainly, calculating the P/E ratio will let you know whether the stock is overvalued, undervalued, or fairly valued.
Sector Where P/E Ratio is Avoided:
While the P/E ratio is relevant in assessing companies across various sectors, it is particularly important where earnings and growth prospects play a significant role in determining a company's value. However, the P/E ratio is not considered the right metric when analysing the banking industry. In its place, P/B, aka the Price-to-Book ratio, is checked.
The P/B ratio is used to evaluate a company's market value in relation to its book value or net asset value. It means that the ratio calculates a bank's market value as compared to its book value.
When it comes to financial ratios, the P/E ratio may be the popular kid in school, but the P/B ratio is the underdog. 🐶
Understand P/E ratios’ importance, and try out some essential examples by going through the well-devised article Why is Price to Earnings (P/E) Ratio important for Company Analysis?
4. Return on Capital Employed (ROCE)
Return on Capital Employed is a financial ratio that measures a company's profitability and efficiency in generating returns from the capital employed in its operations. ROCE is a key metric to assess a company's financial performance and the efficiency with which it utilises its invested capital.
In easy terms, ROCE helps one understand how much profit the company earns from the capital it invests in its operations.
A Factor that Makes ROCE Unique
Unlike other profitability ratios that measure returns relative to sales or assets, ROCE hones in on the capital's efficiency and effectiveness in generating profits from core operations. It provides a direct link between the money invested in the company and the profitability of those investments. Capitalising on the “capital” is the key! 😌
Learn what more the ROCE suggests in a company by reading the article What is Return on Capital Employed?
5. Debt to Equity Ratio
The Debt-to-Equity (D/E) ratio is a leverage ratio that measures a company's financial leverage or its level of indebtedness. It is also known as the 'Risk Ratio' or 'Gearing'. The D/E ratio is calculated by dividing a company's total debt by its total equity.
Simply put, with the D/E ratio, one can decipher how much a company depends on borrowed funds and how much it is faring on its financial assets.
Sectors Where High D/E Ratio is Not Bad
Although avoiding companies with high debt is a good call, there are several industries whose business models need large amounts of capital. Capital-intensive sectors like utilities and telecommunications thus have higher D/E ratios as compared to IT or pharmaceutical companies. So, while you are analysing a company’s stock, make sure to see which sector it belongs to.
You don't want to look for a D/E ratio suitable for an IT company while analysing a cement company!
So, take a dive into the possibilities of calculating the D/E ratio for companies by reading the article What is Debt to Equity Ratio?
The Bottom Line
And we are at the end of our listicle. To conclude this lesson, I want to remind you that although these five ratios are of utmost importance while analysing a company, they are not a definite tool. There is no guarantee or right answer for finding the relevant choice for your portfolio. So, instead of mindlessly following the numbers, follow your intuition and research material.
And don't forget to follow the three P's of investing - Patience, Persistence, and Pizza (because, let's face it, who doesn't love pizza!) 🍕
*Disclaimer: The stocks and companies discussed above aren't a recommendation from Insider by Finology and shall not be construed as a replacement for professional advice. Consult a professional or conduct the necessary research before making investment decisions.
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