Ratios can be invaluable tools for making decisions about companies you might want to invest in. They are used by individual investors and professional analysts, and there are a variety of ratios to use. Financial ratios are typically cast into four categories:
In this article, we'll look at each category and provide examples of simple-to-use ratios that can help you easily gain important insight into companies you may want to invest in.
- Ratios—one variable divided by another—are used widely in financial analysis to understand how companies are doing internally and relative to one another.
- Financial ratios can be computed using data found in financial statements, such as the balance sheet and income statement, and form the basis of fundamental analysis.
- In general, there are four common types of measures used in ratio analysis: profitability, liquidity, solvency, and valuation.
- Common examples of ratios include the price-to-earnings (P/E) ratio, net profit margin, and debt-to-equity (D/E).
Analyze Investments Quickly With Ratios
In general, profitability analysis seeks to analyze business productivity from multiple angles using a few different scenarios. Profitability ratios help provide insight into how much profit a company generates and how that profit relates to other important information about the company. These are used to assess a business's ability to generate earnings relative to its revenue, operating costs, balance sheet assets, and shareholders' equity over time, using data from a specific point in time.
Some key profitability ratios include:
- Gross margin (and adjusted gross margin)
- Operating margin
- Net profit margin
- EBITDA margin
- Operating cash flow margin
- Return on assets (ROA)
- Return on equity (ROE)
- Return on invested capital (ROIC)
- Return on investment (ROI)
One of the leading ratios used by investors for a quick check of profitability is the net profit margin.
Example: Net Profit Margin
Profit Margin=RevenueNet Income
This ratio compares a company’s net income to its revenue. In general, the higher a company's profit margin, the better. A net profit margin of 1, or 100%, means a company is converting all of its revenue to net income.
Profit margin levels vary across industries and time periods as this ratio can be affected by several factors. Thus, it is also helpful to look at a company's net profit margin versus the industry and the company’s historical average.
With net profit margin, there can be a few red flags you should watch out for, especially if the company sees decreasing profit margins year-over-year. Oftentimes, this suggests changing market conditions, increasing competition, or rising costs.
If a company has a very low-profit margin, it may need to focus on decreasing expenses through wide-scale strategic initiatives. A high-profit margin relative to the industry may indicate a significant advantage in economies of scale, or potentially some accounting schemes that may not be sustainable for the long term.
Liquidity measures how quickly a company can repay its debts. It also shows how well company assets cover expenses.
Liquidity ratios give investors an idea of a company’s operational efficiency. They also show how quickly and easily a company generates cash to purchase additional assets or to repay creditors quickly, either in an emergency situation or in the course of normal business.
Some of the key liquidity ratios include:
- Current ratio
- Quick ratio
- Cash ratio
- Cash conversion cycle (CCC)
- Operating cash flow ratio
- Receivables turnover
- Inventory turnover
- Working capital turnover
Example: Quick & Current Ratios
The current and quick ratios are great ways to assess the liquidity of a firm. Both ratios are very similar.
The current ratio is calculated by dividing current assets by current liabilities. Since current assets and current liabilities represent activity in the upcoming 12 months, this ratio can provide insight into the firm’s short-term liquidity. A higher current ratio is favorable as it represents the number of times current assets can cover current liabilities.
The quick ratio is nearly the same; however, it subtracts inventory from current assets. This gives better insight into the short-term liquidity of the firm by narrowing the current assets to exclude inventory. Again, a higher quick ratio is better.
Solvency ratios, also known as leverage ratios, are used by investors to get a picture of how well a company can deal with its long-term financial obligations. As you might expect, a company weighed down with debt is probably a less favorable investment than one with a minimal amount of debt on its books.
Some of the most popular solvency ratios include:
- Debt to total assets
- Debt to equity
- Time interest earned
- Interest coverage ratio
- Net income to liabilities
- Times interest earned
Debt to assets and debt to equity are two top ratios often used for a quick check of a company’s debt levels. Both review how debt stacks up against other categories on the balance sheet.
Example: Debt to Assets
The total-debt-to-total-assets ratio is used to determine how much of a company's assets are tied up by debt.
It is calculated as follows:
Total Debt to Total Assets = Total AssetsSTD + LTDwhere:STD=short term debtLTD=long term debt
As a general rule, a number closer to zero is generally better because it means that a company carries less debt compared to its total assets. The more solvent the assets, the better. Remember, lenders typically have the first claim on a company's assets when required to liquidate; therefore, a lower debt/assets ratio typically indicates less risk.
When using this ratio to analyze a company, it can help to look at both the company growth phase and the industry as a whole. It's not unrealistic for a younger company to have a debt-to-total-assets ratio closer to one (with more of its assets financed by debt) as it hasn't had a chance to eliminate its debt.
Valuation ratios are some of the most commonly quoted and easily used ratios for analyzing the attractiveness of an investment in a company. These measures primarily integrate a company’s publicly traded stock price to give investors an understanding of how inexpensive or expensive the company is in the market.
In general, the lower the ratio level, the more attractive an investment in a company becomes. Often, analysts will take the reciprocal of a valuation ratio, or its multiple, as a measure of relative value.
Popular valuation multiples include:
The price-to-earnings (P/E) ratio is one of the most well-known valuation ratios. It compares a company's stock price to its earnings on a per-share basis. Like other valuation ratio analyses, the price to earnings shows the premium that the market is willing to pay.
The P/E ratio is calculated as follows:
Price to Earnings=Earnings Per Share (EPS)Market Value Per Share
This ratio transforms any company's earnings into an easily comparable measure. Basically, it tells you how much investors are willing to pay for $1 of earnings in that company. The higher the ratio, the more investors are willing to spend.
But don't think a higher P/E ratio for one company necessarily suggests that its stock is overpriced. Different industries have substantially different P/E ratios; so, it is important to compare a company's P/E ratio to that of its industry.
The Bottom Line
Ratios are comparison points for companies. They evaluate stocks within an industry. Likewise, they measure a company today against its historical numbers.
In most cases, it is also important to understand the variables driving ratios as management has the flexibility to, at times, alter its strategy to make the company's stock and ratios more attractive. Generally, ratios are typically not used in isolation but rather in combination with other ratios. Having a good idea of the ratios in each of the four previously mentioned categories will give you a comprehensive view of the company from different angles and help you spot potential red flags.
The information you need for calculating ratios is easy to come by as every single number or figure can be found in a company's financial statements. Once you have the raw data, you can plug it right into your financial analysis tools and put those numbers to work for you.
Everyone wants an edge in investing, but one of the best tools is frequently misunderstood and avoided by new investors. Understanding what ratios tell you, as well as where to find all the information you need to calculate them, can give you greater confidence in your investment decisions and potentially help you avoid large losses.