Ratios track company performance.
They can rate and compare one company against another that you might be considering investing in. Ratios can help make you a more informed investor when they’re properly understood and applied.
KEY TAKEAWAYS
- There are six basic ratios that are often used to pick stocks for investment portfolios.
- These ratios include the working capital ratio, the quick ratio, earnings per share (EPS), price-earnings (P/E), debt-to-equity, and return on equity (ROE).
- Most ratios are best used in combination with others rather than singly to accomplish a comprehensive picture of a company’s financial health.
1. Working Capital Ratio
The working capital ratio is useful for measuring liquidity, which refers to how easily a company can convert its assets into cash.
Formula: current assets – current liabilities = working capital
The working capital ratio compares current assets to current liabilities and is used as a metric to assess liquidity.
A working capital ratio of 1 can imply that a company may have liquidity troubles and may not be able to pay its short-term liabilities.
A ratio of 2 or higher can indicate healthy liquidity and the ability to pay short-term liabilities, but it could also suggest that a company has too much in short-term assets such as cash.
2. Quick Ratio
The quick ratio is another measure of liquidity. It represents a company’s ability to pay current liabilities with assets that can be quickly converted to cash.
current assets − inventory prepaid expenses / current liabilities
(current assets minus inventory and prepaid expenses, divided by current liabilities).
The formula removes inventory because it can take time to sell and convert inventory into liquid assets.
A quick ratio of less than 1 can indicate that there aren’t enough liquid assets to pay short-term liabilities.
The company may have to raise capital or take other actions. On the other hand, it may be a temporary situation.
3. Earnings Per Share
Earnings per share (EPS) is a measure of a company’s profitability. Investors use it to gain an understanding of the company’s value.
Analysts calculate EPS by dividing net income by the weighted average number of common shares outstanding during the year.
net income / weighted average = earnings per share
Earnings per share will also be zero or negative if a company has zero earnings or negative earnings, representing a loss.
A higher EPS indicates greater value.
4. Price-Earnings Ratio (P/E)
The P/E ratio is used by investors to determine a stock’s potential for growth. It reflects how much they would pay to receive $1 of earnings.
To calculate the P/E ratio, divide a company’s current stock price by its earnings per share (EPS):
current stock price / earning– per-share = price-earnings ratio
It’s often used to compare the potential value of a selection of stocks.
Investors have been willing to pay more than 20 times the EPS for certain stocks when they believe that future growth in earnings will provide adequate returns on their investments.
The P/E ratio will no longer make sense if a company has zero or negative earnings. It will appear as N/A for “not applicable.
5. Debt-to-Equity Ratio
The debt-to-equity (D/E) ratio measures how much a company is funding its operations using borrowed money. It can indicate whether shareholder equity can cover all debts, if necessary.
Investors often use it to compare the leverage used by different companies in the same industry, which can help them determine which might be a lower-risk investment.
Divide total liabilities by total shareholders’ equity to calculate the debt-to-equity ratio:
total liabilities / total shareholders’ equity = debt-to-equity ratio
However, like all other ratios, this metric must be analyzed in terms of industry norms and company-specific requirements.
6. Return on Equity (ROE)
Return on equity (ROE) measures profitability and how effectively a company uses shareholder money to make a profit. ROE is expressed as a percentage of common stock.
It’s calculated by taking net income (income less expenses and taxes) figured before paying common and preferred share dividends.
A good ROE is one that increases steadily over time.
Divide the result by total shareholders’ equity:
net income (expenses and taxes before paying common share dividends and after paying preferred share dividends) / total shareholders’ equity = return on equity
This could indicate that a company does a good job of using shareholder funds to increase profits, which can in turn increase shareholder value.
The Bottom Line
Financial ratios can help you pick the best stocks for your portfolio and build your wealth.
Dozens of financial ratios are used in fundamental analysis, but the six highlighted here are the most common and the easiest to calculate.
A company cannot be properly evaluated using just one ratio in isolation. Use a variety of ratios for more confident investment decision-making.
You can download the offline guide here 6 Basic Financial Ratios and What They Reveal
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