Top 5 Financial Ratios Every Investor Should Know!
Introduction
Welcome to ARTIFICALAB LTD! We’re thrilled to have you here. At ARTIFICALAB LTD, we are passionate about empowering investors with the knowledge and tools they need to make informed financial decisions.
Today, we’re excited to share with you our latest blog post, “Top 5 Financial Ratios Every Investor Should Know.”
Whether you’re a seasoned investor or just starting your journey, understanding these key financial ratios can significantly enhance your investment strategy. So, sit back, relax, and enjoy learning with us as we dive into the essential financial ratios that can help you navigate the complex world of investing. Let’s get started!
Introduction to Financial Ratios
Financial ratios are quantitative metrics derived from a company’s financial statements, namely including
(1) the Balance Sheet,
(2) the Income Statement, and
(3) the Cash Flow statement.
So, the question is why these kinds of Financial Ratios are so useful to us, especially investors??
Well, to be honest, they provide many valuable insights and could do various assessments on the firm’s valuation and stock analysis. Indeed, these ratios provide insights into various aspects of a company’s performance, including its profitability, liquidity, efficiency, and solvency.
By analyzing financial ratios, investors, analysts, and managers can assess a company’s financial health, compare it with industry peers, and make informed decisions. Financial ratios are essential tools for evaluating investment opportunities, identifying potential risks, and developing strategic plans to enhance business performance.
"A FINANCIAL ANALYST NOT ONLY NEEDS TO UNDERSTAND THESE IMPORTANT RATIOS BUT ALSO HOW TO INTERPRET THEM CORRECTLY, IN ACCORDANCE WITH THE INDUSTRY BENCHMARKS. THESE RATIOS SERVE AS THE ESSENTIAL FOUNDATIONS IN EVERY INDUSTRY OF FINANCIAL ANALYSIS."
— Mr. Thu Ta Naing, Founder (ARTIFICALAB LTD),
CFA Research Challenge Semi-Finalist 2024 (Thailand Local Competition)
1. Price-to-Earnings (P/E) Ratio
Significance:
The P/E ratio measures a company’s current share price relative to its per-share earnings. It indicates how much investors are willing to pay for a dollar of earnings.
How to Use P/E Ratio:
A high P/E ratio may suggest that a stock is overvalued, or investors are expecting high growth rates in the future. Conversely, a low P/E ratio might indicate that the stock is undervalued or that the company is experiencing difficulties. You need to compare the P/E ratio with industry peers and historical averages to make informed decisions.
P/E Ratio = Market Price per Share / Earning per Share (EPS)
To understand better more, now, let's explore with below Case Study on Tesla Inc.
Case Study: Tesla, Inc.
- Context: In 2020, Tesla’s P/E ratio soared as investors anticipated high future growth due to the company’s innovative electric vehicles and expansion plans.
- Analysis: Despite a high P/E ratio, many investors considered Tesla a good buy due to its potential for future earnings growth.
- Takeaway: A high P/E ratio can be justified if the company has strong growth prospects, but it’s essential to compare it with industry peers and consider the broader market context.
2. Debt-to-Equity (D/E) Ratio
Significance:
The D/E ratio compares a company’s total liabilities to its shareholder equity, providing insight into its financial leverage and risk.
How to Use D/E Ratio:
A high D/E ratio indicates that a company is heavily financed by debt, which can be risky if not managed properly. A lower ratio suggests a more conservative approach to financing. Investors should consider the industry norms and the company’s ability to generate sufficient cash flow to service its debt.
D/E Ratio = Total Liabilities / Shareholder's Equity
To understand better more, now, let's explore with below Case Study on General Electric (GE).
Case Study: General Electric (GE)
- Context: GE faced significant challenges in the late 2010s due to its high D/E ratio, which raised concerns about its ability to manage debt.
- Analysis: Investors became wary as GE struggled to generate enough cash flow to cover its liabilities, leading to a decline in stock price.
- Takeaway: A high D/E ratio can signal financial distress, especially if the company cannot generate sufficient cash flow to manage its debt.
3. Return on Equity (ROE)
Significance:
ROE measures a company’s profitability by revealing how much profit it generates with the money shareholders have invested.
How to Use ROE Ratio: A higher ROE indicates efficient use of equity capital and strong profitability. Compare the ROE with industry averages and the company’s historical performance to assess its financial health and management effectiveness.
ROE Ratio = Net Income / Shareholder's Equity
For now, let's study with the case study on Apple Inc, which manufactures the key flagship iPhones and other Mac products.
Case Study: Apple Inc.
- Context: Apple consistently reports high ROE, reflecting its efficient use of shareholder equity and strong profitability.
- Analysis: Investors view Apple’s high ROE as a sign of effective management and a profitable business model.
- Takeaway: A high ROE can indicate a well-managed company with strong profitability, making it an attractive investment.
4. Current Ratio
Significance:
The current ratio assesses a company’s ability to pay off its short-term liabilities with its short-term assets. In fact, you need to remember that it is a measure of liquidity on short-term duration.
How to Use Current Ratio:
Usually, a current ratio above 1 indicates that the company has more short-term assets than short-term liabilities, suggesting good liquidity.
However, an excessively high ratio might indicate inefficient use of assets. Therefore, we suggest that you will need to compare the current ratio with industry standards to evaluate the company’s liquidity position.
Current Ratio = Current Assets / Current Liabilities
For now, let's study with the case study on Walmart Inc, a giant retail store chains across the United States
Case Study: Walmart Inc.
- Context: Walmart maintains a healthy current ratio, ensuring it can meet its short-term obligations while efficiently using its assets.
- Analysis: Investors see Walmart’s stable current ratio as a sign of good liquidity management.
- Takeaway: A balanced current ratio indicates good liquidity and efficient asset management, which is crucial for operational stability.
5. Earnings Per Share (EPS)
Significance:
EPS measures the portion of a company’s profit allocated to each outstanding share of common stock, indicating profitability.
How to Use:
Higher EPS values generally indicate greater profitability. Investors should look at the trend of EPS over time and compare it with competitors to gauge the company’s performance. EPS growth can be a strong indicator of future potential.
EPS = (Net Income - Dividends on Preferred Stock) / Average Outstanding Shares
Now, let's study how to analyze with EPS on the Microsoft Inc.
Case Study: Microsoft Corporation
- Context: Microsoft has shown consistent EPS growth over the years, reflecting its strong profitability and successful business strategies.
- Analysis: Investors consider Microsoft’s growing EPS as a positive indicator of its financial health and future potential.
- Takeaway: Consistent EPS growth is a strong indicator of a company’s profitability and potential for future success.
CONCLUSION
Understanding these key financial ratios and seeing their application in real-world scenarios can empower investors to make more informed and strategic investment decisions.
By analyzing the P/E ratio, D/E ratio, ROE, current ratio, and EPS, you can gain valuable insights into a company’s financial health and growth potential. Remember to compare these ratios with industry benchmarks and historical data to get a comprehensive view. Happy investing!
