Financial ratios help you interpret any company’s finances’ raw data to get actionable inputs on its overall performance. You can source the ratios from a company’s financial statements to evaluate its valuation, rates of return, profitability, growth, margins, leverage, liquidity, and more.
In simple words, a financial ratio involves taking one number from a company’s financial statements and dividing it by another. The resulting answer gives you a metric that you can use to compare companies to evaluate investment opportunities.
For example, just knowing that a company’s share price is $20 doesn’t offer any insight. But knowing that the company’s price to earnings ratio (P/E) is 4.5 gives you some more context. It means that the price ($20), when divided by its earnings per share (EPS, in this case, 4.44), equals 4.5. You can now compare the P/E of 4.5 to that of other companies, competitors, or even to the company’s historical P/E ratio to better understand the investment’s overall attractiveness.
Different financial ratios offer different aspects of a company’s financial health, from how it can cover its debt to how it utilizes its assets. A single ratio may not cover the company’s entire performance unless viewed as part of a whole.
These ratios are time-sensitive as they assess data that changes over time. So you can use these ratios to your benefit by comparing them from different periods to get a general idea of a company’s growth or regression over time.
There are five broad categories of financial ratios. Let’s look at them individually –
Liquidity ratios tell a company’s ability to pay its debt and other liabilities. By analyzing liquidity ratios, you can gauge if the company has assets to cover long-term obligations or the cash flow is enough to cover overall expenses. If the answers are positive, you may say the company has adequate liquidity, or else there may be problems.
These liquidity ratios are notably more critical with small-cap and penny stocks. Newer and smaller companies often have difficulties covering their expenses before they stabilize.
Some common liquidity ratios are
Leverage or solvency ratios offer insight into a company’s ability to clear its long-term debts. These ratios evaluate the company’s dependence on debt for its regular operations and the possibility to repay the obligations.
Some common leverage ratios are
Valuation ratios generally rely on a company’s current share price and reveal whether the stock is an attractive investment option at the time. You can also call these ratios are market ratios as they examine a company’s attractiveness in the stock market.
Some common valuation ratios are:
As the name indicates, performance ratios reveal a company’s market performance (profit or loss). These ratios are also called profitability ratios.
Some common profitability ratios are
Activity ratios demonstrate a company’s efficiency in operations. In other words, you can see how well the company uses its resources, such as the assets available, to generate sales.
Some commonly used activity ratios are:
Ratio analysis can predict a company’s future performance—for better or worse. Successful companies generally boast solid ratios in all areas, where any sudden hint of weakness in one area may spark a significant stock sell-off. While using these financial ratios, investors must be careful about each’s nuances and use them in tandem for a comprehensive analysis of a stock.
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