6 basic financial ratios and what they reveal (2023)

Indices track the performance of the company. They can rate and compare one company to another you might be considering investing in. The term "ratio" conjures up complex and frustrating high school math problems, but that doesn't have to be the case. Indices can help you become a more informed investor when they areproperly understood and applied.

key takeaways

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

1. Working Capital Ratio

Evaluating the health of a company in which you want to invest implies measuring itsliquidity. The term liquidity refers to the ease with which a company can convert assets into cash to pay short-term obligations. The working capital ratio can be useful to help you gauge liquidity. It represents the ability of a company to pay its current liabilities with its current assets.

working capitalis the difference between a company's current assets and current liabilities:current assets - current liabilities = working capital.

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

Let's say Company XYZ has current assets of $8 million and current liabilities of $4 million. The working capital ratio is2 ($8 million / $4 million). That is an indication of healthy liquidity in the short term. But what if two similar firms had ratios of 2 each? The company with the most cash in its current assets could pay off its debts more quickly than the other.

A working capital ratio of 1 may imply that a company may have liquidity problems and be unable to pay its liabilities in the short term. But the problem could be temporary and then get better.

(Video) Financial ratio analysis

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

It can be challenging to determine the right category for the wide range of assets and liabilities in a company.balance sheetto decipher a company's overall ability to meet its short-term commitments.

2. Quick relationship

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

The quick ratio calculation iscurrent assets - inventory prepaid expenses / current liabilities(current assets minus inventory minus prepaid expenses divided by current liabilities). The formula eliminates inventory because it can take time to sell and convert toliquid assets.

Company XYZ has $8 million in current assets, $2 million in inventory and prepaid expenses, and $4 million in current liabilities. That means the fast ratio is1.5 ($8 million - $2 million / $4 million). It indicates that the company has enough money to pay its bills and continue operating.

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

3. Earnings per share (EPS)

By buying a stock, you participate in the future earnings or risk of loss of the company. Earnings per share (EPS) is a measure of a company's profitability. Investors use it to understand the value of the company.

(Video) Stock Market for Beginners: Must know Financial Ratios Before Investing in a Stock | CA Aleena Rais

Company analysts calculate EPS by dividing net income byaverage weightnumber 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 a higher value.

4. Price-earnings (P/E) ratio

CalledPHYSICAL EDUCATIONFor short, investors use this ratio to determine a stock's growth potential. It reflects how much they would pay to receive $1 of profit. It is 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 / earnings per share = price-earnings ratio.

The P/E ratio of a company would be9,49 ($46,51 / $4,90)if it closed trading at $46.51 per share and the EPS for the last 12 months averaged $4.90. Investors would spend $9.49 for every dollar of annual earnings generated. Investors have been willing to pay more than 20 times the EPS for certain stocks when they felt that 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".

Indices can help improve your investment results when they are properly understood and applied.

5. Debt-equity ratio

What if your potential investment goal is to borrow too much? This can increase fixed charges, reduce earnings available for dividends, and present a risk to shareholders.

(Video) 6 Basic Financial Ratios and What They Reveal

Hedebt to equity (D/E)The ratio measures how much a company finances its operations with borrowed money. You can indicate whether the share capital 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 determine what might be a lower risk investment.

Divide total liabilities by total owners' equity to calculate the debt-to-equity ratio:total liabilities / total shareholders' equity = debt-to-equity ratio. Let's say Company XYZ has $3.1 million in loans and shareholders' equity of $13.3 million. That results in a modest ratio of 0.23, which is acceptable under most circumstances. But like all other indices, the metric must be looked at in terms of industry norms and company-specific requirements.

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 shareholders' common shares.

It is calculated by taking net income (income less expenses and taxes) calculated before paying dividends on common stock and after paying dividends on preferred stock. Divide the result by total shareholders' equity:net income (expenses and taxes before paying common stock dividends and after paying preferred stock dividends) / total shareholders' equity = return on capital.

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

What is a good ROE?

Return on equity or ROE is a metric used to analyze the performance of investments. It is a measure of how effectively a company uses equity capital to generate revenue. You can think of a good ROE as one that steadily increases over time. This could indicate that a company is doing a good job of using shareholder funds to increase profits. That in turn can increase shareholder value.

What is fundamental analysis?

Fundamental analysis is the analysis of a security to discover its true or intrinsic value. It involves the study of economic, industrial and business information. Fundamental analysis can be useful because an investor can determine whether a security is fairly priced, overvalued, or undervalued by comparing its actual 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.

(Video) AARM PSX#019 Six Basic Financial Ratios and what they reveal about company, Fundamental Analysis

Is a higher or lower P/E ratio better?

It depends on what you are looking for in an investment. A P/E ratio measures the relationship between a stock price and earnings per share. A lower P/E ratio may indicate that a stock is undervalued and perhaps worth buying, but it could be low because the company is not in good financial health.

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

The P/E is often best used as a relative value comparison tool for the stocks you are interested in, or you may want to compare the P/E of one or more stocks to an industry average.

The bottom line

Financial indices can help you choose the best stocks for your portfolio and increase your wealth. Dozens of financial ratios are used in fundamental analysis. We have briefly highlighted six of the most common and easy to calculate.

Remember that a company cannot be adequately evaluated using just one index in isolation. Be sure to use a variety of ratios to make investment decisions with greater confidence.

(Video) FINANCIAL RATIOS: How to Analyze Financial Statements


6 basic financial ratios and what they reveal? ›

There are six basic ratios that are often used to pick stocks for investment portfolios. These include the working capital ratio, the quick ratio, earnings per share (EPS), price-earnings (P/E), debt-to-equity, and return on equity (ROE).

What are the six 6 basic financial ratios and what do they reveal? ›

There are six basic ratios that are often used to pick stocks for investment portfolios. These include the working capital ratio, the quick ratio, earnings per share (EPS), price-earnings (P/E), debt-to-equity, and return on equity (ROE).

What are financial ratios and what do they reveal? ›

Ratio analysis compares line-item data from a company's financial statements to reveal insights regarding profitability, liquidity, operational efficiency, and solvency. Ratio analysis can mark how a company is performing over time, while comparing a company to another within the same industry or sector.

What are the five major categories of ratios and what questions do they answer? ›

The five categories of ratios are: Market Profitability Debt Activity Liquidity Also read: Profitability Ratios Accounting Ratios Difference Between Current Ratio and Quick Ratio
  • Market.
  • Profitability.
  • Debt.
  • Activity.
  • Liquidity.

What do financial ratios reveal how a business is doing? ›

Profitability ratios measure income relative to sales and resources, determining the ability of a company to generate earnings and effective employment of resources. It is considered that a company is doing well when a profitability ratio has a higher value relative to the same ratio from a previous period.

What are the 6 basic financial statements? ›

The usual order of financial statements is as follows:
  • Income statement.
  • Cash flow statement.
  • Statement of changes in equity.
  • Balance sheet.
  • Note to financial statements.

What are the 6 financial principles of financial management? ›

Six financial literacy principles
  • Budget your money. “Pay yourself first” ...
  • Taxation – it's not all yours. “Understand your true earnings and how they are taxed” ...
  • Borrowing. “Not all money is created equal” ...
  • Plan before investing. “Think about and map your goals” ...
  • Invest to achieve your goals. ...
  • Preparing your estate.

Which financial ratio is the most important and why? ›

Return on equity ratio

This is one of the most important financial ratios for calculating profit, looking at a company's net earnings minus dividends and dividing this figure by shareholders equity. The result tells you about a company's overall profitability, and can also be referred to as return on net worth.

What are the types of ratios most commonly used in financial analysis? ›

The common financial ratios every business should track are 1) liquidity ratios 2) leverage ratios 3)efficiency ratio 4) profitability ratios and 5) market value ratios.

How do you summarize financial ratios? ›

The four key financial ratios used to analyse profitability are:
  1. Net profit margin = net income divided by sales.
  2. Return on total assets = net income divided by assets.
  3. Basic earning power = EBIT divided by total assets.
  4. Return on equity = net income divided by common equity.

What is the rule of thumb for financial ratios? ›

A general rule of thumb is to have a current ratio of 2.0. Although this will vary by business and industry, a number above two may indicate a poor use of capital. A current ratio under two may indicate an inability to pay current financial obligations with a measure of safety.

What are the five ratios used to Analyse a balance sheet? ›

Useful Balance Sheet Ratios — And How to Calculate Them
  • Inventory Turnover Ratio.
  • Receivable Turnover Ratio.
  • Payables Turnover Ratio.
  • Asset Turnover Ratio.
  • Net Working Capital Ratio.

What are financial ratios and their main users provide examples? ›

Financial ratios are relationships determined from a company's financial information and used for comparison purposes. Examples include such often referred to measures as return on investment (ROI), return on assets (ROA), and debt-to-equity, to name just three.

What are four main types of financial ratios used in ratio analysis? ›

What are the four types of financial ratios?
  • Liquidity ratios.
  • Activity ratios (also called efficiency ratios)
  • Profitability ratios.
  • Leverage ratios.

What are the ratios that are based on financial statement values? ›

There are five basic financial statement ratios that we can use to see how well a company is performing. They are the current ratio, the quick ratio, earnings per share, debt-to-assets ratio, and the return on equity. The first ratio is called the current ratio, or the working capital ratio.

What are the basics of financial analysis? ›

The financial analysis aims to analyze whether an entity is stable, liquid, solvent, or profitable enough to warrant a monetary investment. It is used to evaluate economic trends, set financial policies, build long-term plans for business activity, and identify projects or companies for investment.

What are the 4 most important financial statements? ›

For-profit businesses use four primary types of financial statement: the balance sheet, the income statement, the statement of cash flow, and the statement of retained earnings.

Which ratio is most helpful in appraising profitability? ›

Return on capital employed (ROCE)

Capital employed represents the debt and equity with which the company generates profits. ROCE is generally considered to be the primary profitability ratio as it shows how well a business has generated profit from its long-term financing.

What are the golden rules of accounting? ›

Take a look at the three main rules of accounting: Debit the receiver and credit the giver. Debit what comes in and credit what goes out. Debit expenses and losses, credit income and gains.

What are the 6 common elements for basic financial planning models? ›

A business financial plan typically has six parts: sales forecasting, expense outlay, a statement of financial position, a cash flow projection, a break-even analysis and an operations plan. A good financial plan helps you manage cash flow and accounts for months when revenue might be lower than expected.

What are the six essential components of financial planning? ›

The six components of a financial plan include tracking income and expenses, budgeting, saving and investing, insurance, and retirement planning. By understanding and implementing these components, freelancers can create a secure financial future. It's essential to start planning as soon as possible.

What are the most important personal financial ratios? ›

The most commonly used personal financial ratios are liquidity, savings, asset allocation, inflation protection, tax burden, housing, expenses, and insolvency/credit ratios.

What are the most important financial ratios from income statement? ›

Some of the most common ratios include gross margin, profit margin, operating margin, and earnings per share. The price per earnings ratio can help investors determine how much they need to invest in order to get one dollar of that company's earnings.

What are the most important financial ratios to analyze a bank? ›

Common ratios to analyze banks include the price-to-earnings (P/E) ratio, the price-to-book (P/B) ratio, the efficiency ratio, the loan-to-deposit ratio, and capital ratios.

What is a healthy personal financial ratio? ›

Generally speaking, you want to aim for a saving rate of 10 to 20 percent. Younger people may want to aim for a 10 percent savings ratio, and then gradually increase their savings rate as their income increases.

What are four 4 fundamental financial ratios? ›

Financial ratios can be computed using data found in financial statements such as the balance sheet and income statement. In general, there are four categories of ratio analysis: profitability, liquidity, solvency, and valuation.

What ratio is used to measure financial risk? ›

The most common ratios used by investors to measure a company's level of risk are the interest coverage ratio, the degree of combined leverage, the debt-to-capital ratio, and the debt-to-equity ratio.

What are the 3 main uses of financial ratios? ›

Uses of Financial Ratio
  • Enables a company to track its performance –Financial ratio helps a company in tracking its value over time. ...
  • Allows a company to make a comparative judgment regarding its performance – Financial ratios help a company determine its performance in terms of the industry average.
Jul 20, 2022

What's a good debt-to-equity ratio? ›

The optimal debt-to-equity ratio will tend to vary widely by industry, but the general consensus is that it should not be above a level of 2.0. While some very large companies in fixed asset-heavy industries (such as mining or manufacturing) may have ratios higher than 2, these are the exception rather than the rule.

What is a good return on equity? ›

What is a good return on equity? While average ratios, as well as those considered “good” and “bad”, can vary substantially from sector to sector, a return on equity ratio of 15% to 20% is usually considered good. At 5%, the ratio would be considered low.

What is something to watch out for when using financial ratios? ›

Lack of Comparability Between Companies

Using ratios to compare two firms in the same industry may be difficult if, for example, a company uses a last-in-first-out valuation, its ratios that include inventory will be significantly different than a company that uses first-in-first-out.

What is the most important aspect of ratio analysis? ›

The most important aspect of ratio analysis is that it makes it easy to understand the actual financial performance and position of the company that cannot be reliably measured by merely looking at the financial statements of the company.

What are the 5 major categories of ratio? ›

Ratio analysis consists of calculating financial performance using five basic types of ratios: profitability, liquidity, activity, debt, and market.

What are the financial ratios used in accounting? ›

Common accounting ratios include the debt-to-equity ratio, the quick ratio, the dividend payout ratio, gross margin, and operating margin. Accounting ratios are used by both the company itself to make improvements or monitor progress as well as by investors to determine the best investment option.

What are three of the most important techniques in financial analysis? ›

Several techniques are commonly used as part of financial statement analysis. Three of the most important techniques are horizontal analysis, vertical analysis, and ratio analysis.

What are the 5 types of basic financial statement? ›

5 Types of Financial Reports and Their Benefits for Business
  • Balance Sheet.
  • Income Statement.
  • Cash Flow Statement.
  • Statement of Changes in Capital.
  • Notes to Financial Statements.
Dec 28, 2022

What are the 5 methods of financial analysis? ›

What are the five methods of financial statement analysis? There are five commonplace approaches to financial statement analysis: horizontal analysis, vertical analysis, ratio analysis, trend analysis and cost-volume profit analysis. Each technique allows the building of a more detailed and nuanced financial profile.

What are the six 6 stages in the process that makes up the flow of accounting? ›

The steps in the accounting cycle are identifying transactions, recording transactions in a journal, posting the transactions, preparing the unadjusted trial balance, analyzing the worksheet, adjusting journal entry discrepancies, preparing a financial statement, and closing the books.

What are the basic types of financial ratios? ›

What are the four types of financial ratios?
  • Liquidity ratios.
  • Activity ratios (also called efficiency ratios)
  • Profitability ratios.
  • Leverage ratios.

What is Step 6 preparation of the financial statements? ›

Step 6: Reconcile Bank Accounts

Conduct a bank reconciliation, and create journal entries to record all adjustments required to match the accounting records to the bank statement.

What are the six steps in the financial planning process give an example? ›

The six steps of the financial planning advice process
  • #1: Client introduction and establishing the relationship. ...
  • #2: Gather information and determine goals. ...
  • #3: Analyse and evaluate financial position. ...
  • #4: Present analysis and recommended advice. ...
  • #5: Implement recommendations. ...
  • #6: Review the financial plan.
Jul 12, 2022

What are the 6 elements of accounting? ›

Accounting Elements. The accounting elements are Assets, Liabilities, Owners Equity, Capital Introduced, Drawings, Revenue and Expenses.

What are six 6 common fundamental functions that an accounting information systems provide? ›

The six components of an AIS all work together to help key employees collect, store, manage, process, retrieve, and report their financial data. Having a well-developed and maintained accounting information system that is efficient and accurate is an indispensable component of a successful business.

What are the six components of an accounting information system explain? ›

Accounting information systems generally consist of six primary components: people, procedures and instructions, data, software, information technology infrastructure, and internal controls.

How do you memorize financial ratios? ›

Simply trying to memorize the equations themselves will make it difficult to remember each one as you go about trying to recall them later. Instead, write down each ratio and work each out several time using different numbers until you have a firm grasp of what each one means.

What is the most commonly used financial ratios? ›

Return on equity ratio

This is one of the most important financial ratios for calculating profit, looking at a company's net earnings minus dividends and dividing this figure by shareholders equity. The result tells you about a company's overall profitability, and can also be referred to as return on net worth.

How do you analyze financial ratios? ›

The four key financial ratios used to analyse profitability are:
  1. Net profit margin = net income divided by sales.
  2. Return on total assets = net income divided by assets.
  3. Basic earning power = EBIT divided by total assets.
  4. Return on equity = net income divided by common equity.

What are the 4 basic financial statements in order of preparation? ›

Breaking Down the Order of Financial Statements
  • First: The Income Statement.
  • Second: Statement of Retained Earnings.
  • Third: Balance Sheet.
  • Fourth: Cash Flow Statement.
Mar 11, 2020

What are the five basic elements of a complete set of financial statements? ›

The elements of the financial statements will be assets, liabilities, net assets/equity, revenues and expenses. It is noted in Study 1 that moving along the spectrum from cash to accrual accounting does not mean a loss of the cash based information which can still be generated from an accrual accounting system.

What are the six major steps of the accounting process quizlet? ›

The steps of the accounting process are analyzing, recording, classifying, summarizing, reporting, and interpreting. Computers are often used in the recording, classifying, summarizing, and reporting.


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