Ratio - the term is enough to curl one's hair, conjuring up those complex problems we encountered in high school math that left many of us babbling and frustrated. But when it comes to investing, that need not be the case. In fact, there are ratios that, properly understood and applied, can help make you a more informed investor. (Find out how this method can be applied strategically to increase profit. Check out Fundamental Analysis For Traders.)
IN PICTURES: 9 Simple Investing Ratios You Need To Know
1. Working Capital Ratio
Assessing the health of a company in which you want to invest involves understanding its liquidity - how easily that company can turn assets into cash to pay short-term obligations. The working capital ratio is calculated by dividing current assets by current liabilities.
So, if XYZ Corp. has current assets of $8 million, and current liabilities of $4 million, that's a 2:1 ratio - pretty sound. But if two similar companies each had 2:1 ratios, but one had more cash among its current assets, that firm would be better able to pay off its debts quicker than the other.
2. Quick Ratio
Also called the acid test, this ratio subtracts inventories from current assets, before dividing that figure into liabilities. The idea is to show how well current liabilities are covered by cash and by items with a ready cash value. Inventory, on the other hand, takes time to sell and convert into liquid assets. If XYZ has $8 million in current assets minus $2 million in inventories over $4 million in current liabilities, that's a 1.5:1 ratio. Companies like to have at least a 1:1 ratio here, but firms with less than that may be okay because it means they turn their inventories over quickly.
3. Earnings per Share
When buying a stock, you participate in the future earnings (or risk of loss) of the company. Earnings per share (EPS) measures net income earned on each share of a company's common stock. The company's analysts divide its net income by the weighted average number of common shares outstanding during the year.
4. Price-Earnings Ratio
Called P/E for short, this ratio reflects investors' assessments of those future earnings. You determine the share price of the company's stock and divide it by EPS to obtain the P/E ratio.
If, for example, a company closed trading at $46.51 a share and EPS for the past 12 months averaged $4.90, then the P/E ratio would be 9.49. Investors would pay $9.49 for every generated dollar of annual earnings.
Even so, investors have been willing to pay more than 20 times the EPS for certain stocks if hunch that future growth in earnings will give them an adequate return on their investment.
Use the Investopedia Stock Simulator to trade stocks risk free!
5. Debt-Equity Ratio
What if your prospective investment target is borrowing too much? This can reduce the safety margins behind what it owes, jack up its fixed charges, reduce earnings available for dividends for folks like you and even cause a financial crisis.
The debt-to-equity is calculated by adding outstanding long and short-term debt, and dividing it by the book value of shareholders' equity. Let's say XYZ has about $3.1 million worth of loans and had shareholders' equity of $13.3 million. That works out to to a modest ratio of 0.23, which is acceptable under most circumstances. However, like all other ratios, the metric has to be analyzed in terms of industry norms and company specific requirements.
6. Return on Equity
Common shareholders want to know how profitable their capital is in the businesses they invest it in. Return on equity is calculated by taking the firm's net earnings (after taxes), subtracting preferred dividends, and dividing the result by common equity dollars in the company.
Let's say net earnings are $1.3 million and preferred dividends are $300,000. Take that and divide it by the $8 million in common equity. That gives a ROE of 12.5%. The higher the ROE, the better the company is at generating profits.
The Bottom Line
Applying formulae to the investment game may take some of the romance out of the process of getting rich slowly. But the above ratios could help you pick the best stocks for your portfolio, build your wealth and even have fun doing it. (For more, check out our Financial Ratio Tutorial.)
Catch up on your financial news; read Water Cooler Finance: The New iPod And The Roller Coaster Market.
InvestingManagers must make investment decisions based on their personal investment process, which in turn should be based on solid research and due diligence.
Forex EducationLearn how to use revenue and expenses, among other factors, to break down and analyze a company.
ProfessionalsIdentify questions commonly asked at financial auditor job interviews, and learn to formulate winning responses that give your candidacy a boost.
InvestingWhile stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
Mutual Funds & ETFsThe coveted compensations of hedge fund managers are protected by barriers of entry to the industry, but one recent startup is working to break those barriers.
InvestingWe share some lessons from friends and family on saving money and planning for retirement.
InvestingThere are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
EconomicsAfter the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
ProfessionalsLearn what a typical early morning to late evening workday for a hedge fund manager consists of and looks like from beginning to end.
Stock AnalysisLearn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
Hedge funds can trade penny stocks. In fact, hedge funds can trade in just about any type of security, including medium- ... Read Full Answer >>
Alternative investment vehicles such as hedge funds offer investors a wider range of possibilities due to certain exceptions ... Read Full Answer >>
Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
You can replicate hedge fund returns to a degree but not perfectly. Most replication strategies underperform hedge funds ... Read Full Answer >>
Working capital as current assets cannot be depreciated the way long-term, fixed assets are. In accounting, depreciation ... Read Full Answer >>