Financial Ratios Explained

This guide introduces the most significant financial ratios that investors use to gauge the health of a company.

A financial ratio comes from a financial statement, and is simply one number divided by another. These ratios describe a company’s debt leverage, profitability, financial efficiency and more.

You can find these ratios from many different sources, including Finviz.

This spreadsheet lets you compare financial ratios for up to ten different companies by automatically downloading data from the web. Just enter a stock ticker, and the spreadsheet fills with ratios like the PE, PEG, Dividend Yield and more. It’s a great tool for filtering financially healthy companies from the less attractive.

Earnings per Share

The Earnings per Share (or EPS) is the profit divided by the number of outstanding shares – it represents your share of the company profits for every share you own. Preferred shares are not included, and the company may issue more shares. This value is quoted everywhere, and should be easy to find for any single company.

EPS Equation

A share issue increases the number of shares, and hence dilutes (or reduces) EPS. If revenue from the share issue is successfully used to fund a growth in the business, then EPS will eventually increases.

EPS is significant in determining share price. Several variants exist

  • Current EPS, which is based on this year’s project earnings
  • Trailing EPS, which is based on last year’s figures,
  • Forward EPS, which again is based on projected earnings

EPS can be easily manipulated because it is based on net income. For example, management can shift revenue and expenses from one quarter to another.

Price to Earnings Ratio

Any investor worth their salt needs to be familiar with the Price to Earnings ratio (or PE).  It represents how much an investor pays for every dollar the company earns, and is a fundamental measure of stock value.

PE

PE needs to be interpreted carefully. A company with a low P/E could be considered better value for investors, or it could be that the market have marked the company down because of poor future prospects.

If an investor purchases shares in a company with a high P/E, they may be expecting superior future earnings growth relative to the share price.

Scrutinized alone, PE does not describe the value of a company. Usually, the PE of several companies in one sector are analyzed together, since different industries will grow at different rates.

Price/Earnings to Growth Ratio

The Price/Earnings to Growth Ratio (PEG) is only relevant growing companies with an above average PE for the industry. PEG helps investors decide if a growing company with an increasing EPS is fairly priced.

Price/Earnings to Growth Ratio

A PEG lower than one means that the company is undervalued, and vice versa.

Price to Sales Ratio

The Price-to-Sales (PS) ratio compares the share price of a company to its sales per share.  It measures how much the stock market values the company’s sales.

PS

All other parameters being equal, a lower value is better.

The PS ratio is used to filter companies in an industry that has suffered a setback. For example, computer chip manufacturing is cyclical, and the entire industry can suffer years of significantly reduced earnings (and hence the PE ratio cannot be calculated). A company within that industry with a lower PS ratio than its peers will have better prospects than the others.

Debt to Equity Ratio

This ratio compares how much suppliers and creditors have given the company versus the amount given by shareholders. The lower the value, the stronger the equity position.

Debt to Equity Ratio

Good debt to equity ratios vary from industry to industry, with capital-intensive industries having higher values.

Dividend Yield

This is the annual dividend paid out per share divided by the share price. The dividend yield can be compared to the prevailing risk-free interest rate to determine if a company represents a good investment.

Dividend Yield

The dividend yield is a measure of a company’s stability. A company that has paid out a constant stream of dividends over many years is often considered safe. An investor that needs a cash flow, for example, may invest in a portfolio of stocks with high and consistent dividend yields.

Price to Book Ratio

The Price to Book Ratio compares the share price to an estimate of the value of the company (per share). It’s often used by value investors.

Price to Book Ratio

The denominator is essentially how much money would be left if the company was sold and the assets sold to pay any debts and liabilities.

Dividend Payout Ratio

The Dividend Payout ratio quantifies how much of a company’s earnings (per share) are paid out as dividends (per share). In the UK, this ratio is called the Dividend Cover.

Dividend Payout Ratio

The Dividend Payout ratio needs to interpreted carefully. For example, a company with a high Dividend Payout ratio may not be investing for future growth; in this case, the dividend is at risk of being reduced. A rapidly growing company that is investing in future expansion may only have a low Dividend Payout ratio.

Retained earnings are earnings not paid as dividends.

Mature, stable companies in well-developed markets have a higher Dividend Payout ratio.

Current Ratio

The Current Ratio, also called the working capital position, measures a company’s liquidity. It measures if easily liquidated assets are enough to cover short-term liabilities (i.e. debts due within a year). A higher value is better.

Current Ratio

A higher Current ratio is better, with a value of two indicating good financial health. A value lower than one means that a company would struggle to pay its debt if they were due. This does not mean that the company is at risk of bankruptcy

The Current ratio can be too high. A value higher than 3 could mean that the company’s management may be hoarding cash and not investing for growth.

Current ratios should only be compared between companies in the same industry; a high or low current ratio would only make sense in this context.

The Quick ratio is a more conservative version of the Current ratio. The Quick ratio does not include inventory in the current assets, as these may not be easily liquidated.


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