11/3/23, 6:58 PM 6 Basic Financial Ratios and What They Reveal

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CORPORATE FINANCE FINANCIAL RATIOS

6 Basic Financial Ratios and What They

Reveal
By GLENN WILKINS Updated October 13, 2023
Reviewed by NATALYA YASHINA
Fact checked by SUZANNE KVILHAUG

Ratios track company performance. They can rate and compare one company
against another that you might be considering investing in. The term "ratio"
conjures up complex and frustrating high school math problems, but that need
not be the case. Ratios can help make you a more informed investor when
they're properly understood and applied.

KEY TAKEAWAYS
Fundamental analysis relies on data from corporate financial
statements to compute various ratios.
Fundamental analysis is used to determine a security's intrinsic or true
value so it can be compared with the security's market value.
There are six basic ratios that are often used to pick stocks for
investment portfolios.
Ratios include the working capital ratio, the quick ratio, earnings per
share (EPS), price-earnings (P/E), debt-to-equity, and return on equity
(ROE).
Most ratios are best used in combination with others rather than singly
to accomplish a comprehensive picture of a company's financial
health.

1. Working Capital Ratio

Assessing the health of a company in which you want to invest involves
measuring its liquidity. The term liquidity refers to how easily a company can
turn assets into cash to pay short-term obligations. The working capital ratio
can be useful in helping you measure liquidity. It represents a company's ability
to pay its current liabilities with its current assets.

Working capital is the difference between a firm’s current assets and current
liabilities: current assets - current liabilities = working capital.

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The working capital ratio, like working capital, compares current assets to
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current liabilities and is a metric used to measure liquidity. The working capital
ratio is calculated by dividing current assets by current liabilities: current assets
/ current liabilities = working capital ratio.

Let's say that XYZ company has current assets of $8 million and current
liabilities of $4 million. The working capital ratio is 2 ($8 million / $4 million).
That's an indication of healthy short-term liquidity. But what if two similar
companies each had ratios of 2? The firm with more cash among its current
assets would be able to pay off its debts more quickly than the other.

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A working capital ratio of 1 can imply that a company may have liquidity
troubles and not be able to pay its short-term liabilities. But the trouble could
be temporary and later improve.

A working capital ratio of 2 or higher can indicate healthy liquidity and the
ability to pay short-term liabilities, but it could also point to a company that has
too much in short-term assets such as cash. Some of these assets might be
better used to invest in the company or to pay shareholder dividends. [1]

FAST FACT
It can be a challenge to determine the proper category for the vast
array of assets and liabilities on a corporate balance sheet to
decipher the overall ability of a firm to meet its short-term
commitments.

2. Quick Ratio
The quick ratio is also called the acid test. It's another measure of liquidity. It
represents a company's ability to pay current liabilities with assets that can be
converted to cash quickly.

The calculation for the quick ratio is current assets - inventory prepaid
expenses / current liabilities (current assets minus inventory minus prepaid
expenses divided by current liabilities). The formula removes inventory
because it can take time to sell and convert inventory into liquid assets. [2]

XYZ company has $8 million in current assets, $2 million in inventory and

prepaid expenses, and $4 million in current liabilities. That means the quick
ratio is 1.5 ($8 million - $2 million / $4 million). It indicates that the company
has enough to money to pay its bills and continue operating.

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A quick ratio of less than 1 can indicate that there aren't enough liquid assets to
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pay short-term liabilities. The company may have to raise capital or take other
actions. On the other hand, it may be a temporary situation.

3. Earnings Per Share (EPS)

When buying a stock, you participate in the future earnings or the risk of loss of
the company. Earnings per share (EPS) is a measure of the profitability of a
company. Investors use it to gain an understanding of company value.

The company's analysts calculate EPS by dividing net income by the weighted
average number of common shares outstanding during the year: net income /
weighted average = earnings per share. Earnings per share will also be zero or
negative if a company has zero earnings or negative earnings representing a
loss. A higher EPS indicates greater value. [3]

4. Price-Earnings Ratio (P/E)

Called P/E for short, this ratio is used by investors to determine a stock's
potential for growth. It reflects how much they would pay to receive $1 of
earnings. It's often used to compare the potential value of a selection of stocks.

To calculate the P/E ratio, divide a company's current stock price by its
earnings-per-share to calculate the P/E ratio: current stock price / earning- per-
share = price-earnings ratio. [4]

A company's P/E ratio would be 9.49 ($46.51 / $4.90) if it closed trading at

$46.51 a share and the EPS for the past 12 months averaged $4.90. Investors
would spend $9.49 for every generated dollar of annual earnings. Investors
have been willing to pay more than 20 times the EPS for certain stocks when
they've felt that a future growth in earnings would give them adequate returns
on their investments.

The P/E ratio will no longer make sense if a company has zero or negative
earnings. It will appear as N/A for "not applicable."

Important: Ratios can help improve your investing results when

they're properly understood and applied.

5. Debt-to-Equity Ratio
What if your prospective investment target is borrowing too much? This can
increase fixed charges, reduce earnings available for dividends, and pose a risk
to shareholders.

The debt-to-equity (D/E) ratio measures how much a company is funding its
operations using borrowed money. It can indicate whether shareholder equity
can cover all debts, if necessary. Investors often use it to compare the leverage
used by different companies in the same industry. This can help them to
determine which might be a lower-risk investment.

Divide total liabilities by total shareholders' equity to calculate the debt-to-

equity ratio: total liabilities / total shareholders' equity = debt-to-equity ratio.
Let's say that company XYZ has $3.1 million worth of loans and shareholders'

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equity of $13.3 million. That works out to a modest ratio of 0.23, which is
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acceptable under most circumstances. But like all other ratios, the metric must
be analyzed in terms of industry norms and company-specific requirements. [5]

6. Return on Equity (ROE)

Return on equity (ROE) measures profitability and how effectively a company
uses shareholder money to make a profit. ROE is expressed as a percentage of
common stock shareholders.

It's calculated by taking net income (income less expenses and taxes) figured
before paying common share dividends and after paying preferred share
dividends. Divide the result by total shareholders' equity: net income
(expenses and taxes before paying common share dividends and after paying
preferred share dividends) / total shareholders' equity = return on equity. [6]

Let's say XYZ company's net income is $1.3 million. Its shareholder equity is $8
million. ROE is therefore 16.25%. The higher the ROE, the better the company is
at generating profits using shareholder equity.

What's a Good ROE?

Return-on-equity or ROE is a metric used to analyze investment returns. It's a
measure of how effectively a company uses shareholder equity to generate
income. You might consider a good ROE to be one that increases steadily over
time. This could indicate that a company does a good job using shareholder
funds to increase profits. That can in turn increase shareholder value.

What Is Fundamental Analysis?

Fundamental analysis is the analysis of an investment or security to discover its
true or intrinsic value. It involves the study of economic, industry, and company
information. Fundamental analysis can be useful because an investor can
determine if the security is fairly priced, overvalued, or undervalued by
comparing its true value to its market value.

Fundamental analysis contrasts with technical analysis, which focuses on

determining price action and uses different tools to do so, such as chart
patterns and price trends.

Is a Higher or Lower P/E Ratio Better?

It depends on what you're looking for in an investment. A P/E ratio measures
the relationship of a stock's price to earnings per share. A lower P/E ratio can
indicate that a stock is undervalued and perhaps worth buying, but it could be
low because the company isn't financially healthy.

A higher P/E can indicate that a stock is expensive, but that could be because
the company is doing well and could continue to do so. [7]

The best way to use P/E is often as a relative value comparison tool for stocks
you're interested in, or you might want to compare the P/E of one or more
stocks to an industry average.

The Bottom Line

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