Financial ratios are commonly used by companies to determine the financial health of a business. If you’re a prospective investor, who would like to become a shareholder in a company, it’s critical you understand the Earnings per Share (EPS) before checking out other ratios.
EPS refers to the profit that a company makes in a year. Companies with high EPS for the past five years are more robust and stable making them the best to invest in if you are a potential investor. Also, creditors, financial analysts, managers, and shareholders use financial ratios to find out the strength and the weakness of a company.
There are four categories that companies use to analyze financial ratios data.
These ratios measure how a company utilizes its resources. Profitability ratios also help to establish the ability of companies to make sufficient return on sales, total assets, and the sum capital invested. They include:
- Profit margin Ratio – Evaluated by dividing the net income by the purchases made over a period.
- Return On Equity – Determined by calculating the difference between the Net income and Net Equity.
- Gross Margin Ratio – This is the difference between the Gross profit and Net sales
- Return on Investment Assets –This is the difference between the Net Income and Total Assets.
The liquidity ratio of companies is the ability of a company to pay short term loan within 12 months. A company can determine its liquidy rate in this way:
- Current Ratio –The current ratio should be less than 1.0, the company has more short term debts than assets. As a potential investor, always invest in a company with a current rate higher than 1.0
- Quick Ratio – This is the variance between inventory from current assets and the current obligations.
- Operating Cash Flow – The difference between the total debts and the operating cash flow.
- Cash Ratio – The cash ratio is arrived at when you add the marketable securities and the operating cash, then you get the difference of the total with the current liability.
The debt ratio is the difference between the amount of capital borrowed and equity ( the amount of money contributed by shareholders). Its also known as the leveraging ratio or a proportion of a company’s assets that are financed by the company’s debts. Here are the debts ratios that companies look at and which every investor should know.
- Debt Equity Ratio – This is the fraction between long term debt (total liability) versus shareholders equity.
- Total Debt Ratio – This is the difference between the total liabilities and the total assets. It’s riskier to invest in a company if it has a high debt ratio.
- Cash Flow to Debt Ratio –This is the difference between the operating cash flow and total debt.
If a company is capable of converting different accounts of balance sheet into cash or sales, then they have the chance to measure the relative efficiency of the business.
In short, if you’re a potential investor, don’t forget to check out those top three points we’ve discussed here. For more information, check out Investors Hangout.