What are Financial ratios?
Financial ratios are calculated using numerical numbers from financial statements to provide useful information about a company. The data on a company’s financial statements (balance sheet, income statement, and cash flow statement) are used to undertake quantitative analysis and assess liquidity, leverage, growth, margins, profitability, rates of return, value, and other factors.
What are the uses of Financial Ratios?
1. Monitor company performance
Individual financial ratios are calculated for each period and their values are tracked over time to identify trends that may be forming in a company. An growing debt-to-asset ratio, for example, may suggest that a corporation is overwhelmed with debt and may eventually face default risk.
2. Make comparative evaluations of firm performance
Financial ratios are compared to those of key competitors to determine whether a company is performing better or worse than the industry average. Comparing the return on assets of several companies, for example, allows an analyst or investor to assess which company is making the best use of its assets.
Financial ratios are used by both external and internal parties:
External Uses: Retail investors, financial analysts, creditors, competitors, tax and regulatory officials, and industry observers.
Internal Uses: Employees, management, and owners.
Top 5 Financial Ratios
1. Price-to-Earnings Ratio (P/E)
According to Michael Fairbourn, education coach at TD Ameritrade, the price-to-earnings (P/E) ratio is the “most extensively used stock ratio in the world.” The P/E ratio indicates how much investors are ready to pay for a stock over its earnings per share.
For example, a P/E ratio (also known as the “multiple”) of 20 indicates that investors are ready to pay up to 20 times earnings per share to buy the stock. Is that, however, too much or too little? Expensive or inexpensive?
Finally, it may be determined by what a company is capable of doing in terms of future earnings. You may always compare a stock’s P/E to the historical average of the S&P 500, which, according to Fairbourn, is currently about 15. Aside from that, the P/E ratio can’t tell you anything other than what investors are ready to pay right now.
“If a company with a P/E of 35 has a faster growth rate than a company with a P/E of 10, the company on the higher end of the ratio may really be ‘cheaper,'” Fairbourn stated. This leads us to the next ratio.
2. PEG Ratio (Price/Earnings-to-Growth)
The price/earnings-to-growth (PEG) ratio, while not as popular as its P/E counterpart, may provide a more thorough and clear view of a stock’s future growth potential.
You may be familiar with a stock’s P/E ratio, but how does it compare to its predicted growth rate? The price-to-earnings ratio of a firm may be “cheap,” but if the company can’t seem to expand, what’s the sense of owning a stock with a low P/E?
“In this ratio, you’re comparing the P/E to the analyst consensus estimate of expected earnings, which might range from quarterly to five years,” Fairbourn explained. So, how do you interpret this? According to Fairbourn, if the PEG ratio is less than one, investors will generally consider it inexpensive.
What is the significance of the growth component? “You don’t want to buy something that will always be a steal,” Fairbourn explained. “Investors will frequently want to see a track record of growth as well as expected expansion.” This could aid in the validation of an undervalued PEG ratio.”
3. Price-to-Sales Ratio (P/S Ratio)
Some businesses may have high quarterly revenue (another name for “sales”) but low earnings, maybe because they spent a large amount of their money. Some investors are willing to forfeit profits now in exchange for potentially higher returns later. They recognise that certain businesses may need to spend their cash and quarterly sales earnings to grow a larger and better firm for the future. The most crucial factor here is sales.
The price-to-sales (P/S) ratio indicates how much investors are ready to pay beyond a company’s “revenues” (not “earnings,” which are revenues minus liabilities), but gross revenues.
Although revenue is not as “solid” as earnings, as Fairbourn pointed out, there is something fascinating about utilising sales as a basis for valuation.
“In general, sales are prone to less manipulation by management than earnings,” he stated. In other words, sales are simply sales. Although numerous expenses might have an impact on earnings, what a company makes in sales is quite straightforward.
“The P/S ratio helps us comprehend the relationship between a company’s current stock price and its annual sales.” So, if a ratio gives us a reading of.53, it means we’re paying 53 cents per share for every dollar the company produces in revenue,” Fairbourn noted. Does that sound like a deal, or does it sound like a deal?
4. Price-to-Book Ratio (P/B Ratio)
What is the value of a company’s shares in relation to its net asset value (book value)? That is what the price-to-book (P/B) ratio tries to demonstrate.
On the surface, it appears to be a useful indicator for comparing a stock’s market capitalization to “what it owns versus what it owes,” according to Fairbourn.
However, he added a significant caveat: “Depending on the industry, many companies’ asset expenses are priced not according to market value but according to value borne at the time of acquisition.” For example, if a long-standing corporation bought real estate decades ago, the book value of that property may be decades old and not marked-to-market. So, in order to determine a company’s true book worth, you may need to look outside the books.
5. Debt-to-Equity Ratio (D/E Ratio)
Similarly to a corporation’s book value, we invert the word for this last ratio to determine what a company owes in comparison to what it possesses. The computation is straightforward.
In general, investors prefer a debt-to-equity (D/E) ratio lower than one. A reading of two or higher may be considered as more dangerous. However, it is also dependent on the industry. “Some organisations, such as large industrial energy and mining enterprises, tend to carry greater debt than businesses in other areas,” Fairbourn says.
So, if you find an industry with a higher debt load, it may give a better return at the penalty of increased risk.
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