Understanding Financial Ratios
Anyone learning how to invest in the stock market has probably seen terms like price to earnings and leverage. These are financial ratios, and understanding what they say about a company can mean the difference between picking a winning stock and a loser.
Before beginning the discussion of financial ratios, it's important to lay out some ground rules concerning their use when analyzing stocks. When conducting research, the investor is trying to understand exactly what the financial ratios reveal about the company. Oftentimes, these ratios will vary greatly by industry. Therefore, it's important to understand how a company is performing relative to its industry.
It's equally important to understand how a company is performing relative to the entire market. That is why financial ratios are often quoted alongside both an industry benchmark as well as a ratio for a market index such as the S&P 500.
Stock market analysts like numbers, which means there are a lot of ratios to cover. To help the learning process, they're traditionally separated into six different categories:
- Growth Ratios
- Price Ratios
- Profitability Ratios
- Ratios of Financial Condition
- Investment Ratios
- Management Efficiency Ratios
Growth ratios, or growth rates, tell the analyst just how fast a company is growing. The most important of these ratios include:
- Sales (%): normally stated in terms of a percentage growth from the prior year. Sales is the term used for operating revenues, so it's important to see the sales growth rate as high as possible.
- Net Income (%): growth in net income is even more important than sales because net income tells the investor how much money is left over after all of the operating costs are subtracted from sales.
- Dividends (%): a good indicator of the financial health of a company. Some companies do not pay stock dividends; rather they use these excess profits to reinvest money back into the company to accelerate growth. The change in dividends (%) should never be negative. That is, once a dividend rate is established, a company needs to have a very good reason to decrease the payout.
A financial ratio that normalizes a stock's selling price against a measure of the company's profitability is known as a price ratio, and includes:
- Price / Earnings Ratio: the stock's price divided by the latest 12 months of earnings per share. The P/E ratio is an indicator of the premium the investor will be paying for a stock. It is also an indicator of future growth expectations. In general, low ratios can often mean the market is ignoring the stock for some reason. A relatively high ratio indicates payment of a premium for the stock's "potential" future earnings.
- Price / Sales Ratio: the stock's price divided by the latest 12 months worth of sales. This measure became popular during the dot com years, when companies showed no earnings or profits. For that reason, it is not a very useful measure in today's marketplace.
- Price / Book Value Ratio: the stock's price divided by the book value of the company. A company's book value is a measure of the amount by which assets exceed liabilities (in terms of shareholder's equity). The price / book value rarely falls below 1.0.
- Price / Cash Flow Ratio: identical to price to earnings except that it removes non-cash expenses and other accounting adjustments such as depreciation from that measure.
Also known as profitability margins, these are a measure of a company's operating efficiency. These metrics are normally used to compare a company to its industry (as a benchmark), rather than the overall stock market, since the profitability of companies can vary greatly by industry.
- Gross Margin (%): a ratio of a company's operating revenue to sales. Operating revenue is the company's sales revenue minus the cost of good sold.
- Pretax Margin (%): a ratio of the company's pretax profits divided by operating revenues.
- Net Profit Margin (%): the ratio of net profits to sales. One of the best indicators of the company's efficiency because net profit takes into consideration all expenses of the company. Investors would like to see net profit margins as high as possible.
Ratios of Financial Condition
Evaluating the financial condition of a company consists of two related, but distinct, types of measures. The first has to do with how much money the company has borrowed relative to how much money is "invested" in a company. This concept is known as leverage.
The second measure of financial condition has to do with a company's ability to pay back its creditors in terms of interest payments. The following ratios measure these two aspects of a company's finances:
- Debt / Equity Ratio: a measure of the long-term debt divided by the common stock equity. This financial ratio is a measure of leverage. The lower the debt to equity ratio, the less likely a company will be affected by a downturn in the economy.
- Current Ratio: a measure of the company's current assets divided by current liabilities based on the most recent quarter. The current ratio is used to provide guidance on a company's immediate financial health and its ability to meet current obligations.
- Quick Ratio: also known as the acid test, the quick ratio is the sum of cash and receivables divided by the total current liabilities from the most recent quarter. As such, it's another measure of a company's immediate financial condition.
- Leverage Ratio: calculated by taking the total assets and dividing them by total stock equity. The leverage ratio is an indicator of the company's use of debt. For example, if the ratio is high, then assets far exceed stock equity (meaning the company has a lot of debt relative to equity), and the company is considered leveraged.
- Interest Coverage: the company's latest 12 months' earnings before interest and taxes (EBIT) divided by the latest 12 months' interest expense. Interest coverage tells the analyst how easily a company can meet its debt service. The higher the interest coverage value, the easier it is for the company to pay back its debt.
This next set of financial ratios is used to understand how efficiently the money invested in a company is providing a return to investors.
- Return on Equity: also known as ROE, this metric is calculated by taking the latest 12 months' net income divided by common stock equity. The return on equity ratio is perhaps the most widely used, and most valuable, measure of how well a company is performing for its shareholders. The higher the return on equity, the better.
- Return on Capital: also known as ROC, this measure is calculated by taking the latest 12-months' net income divided by invested capital, which is defined as long term debt plus common stock and preferred equity.
- Return on Assets: also known as ROA, this ratio is determined by taking net income and dividing it by total assets. The metric is used to understand how effectively a company is using their assets to generate earnings.
Management Efficiency Ratios
This last category of financial ratios is unique in that none would be a direct indicator of a stock's quality. That being said, it is important to understand exactly what these ratios are telling the investor:
- Revenue per Employee: calculated by taking revenues and dividing them by the total employees of a company. The revenue per employee ratio allows the analyst to understand the labor intensity of a business.
- Receivables Turnover Ratio: measures how many times accounts receivable has been collected in a given period. Receivables turnover is calculated by taking the last 12 months of sales and dividing by the average receivables from the latest two quarters.
- Inventory Turnover Ratio: determined by taking the cost of sales for the latest 12 months and dividing by the company's average inventory. The resulting ratio tells the analyst how fast the company's products are moving on the marketplace. While a relatively low value indicates the company may be having difficulty selling a product, a value that is too high can indicate inadequate manufacturing capacity.
- Assets Turnover: determined by dividing revenues by sales, this ratio tells the analyst how well a company uses its assets to generate revenue. Companies that require a large infrastructure in order to produce, or deliver their product, such as electric utilities, require a large asset base to generate sales.
Final Words on Financial Ratios
Eventually these ratios are going to be used to help pick stocks using a screening tool. But there are two more lessons before reaching that point. Up next, there is a discussion of insider trading information.
About the Author - Understanding Financial Ratios