When you look at financial statements of a company, how do you know whether the company is doing well? Or is it financially strong or vulnerable? The following ratios will help you in that assessment.
Basically, financial ratios can be grouped into 3 categories:
- Profitability
- Liquidity and solvency: refers to a company’s ability to meet short-term and long-term debt
- Shareholder investment ratios
- Profitability
- Return on capital employed (ROCE)
- ROCE = Profit before interest and taxation/Total assets less current liabilities
- Evaluates how effectively a company uses its capital to generate profits. A higher ROCE is generally favorable as it indicates the company is achieving greater profit from its capital investments.
- Profit margin:
- Profit margin = Profit/Revenue
- Indicates how many cents of profit has been generated for each dollar of sales
- Profit margin varies by industries so it should be used carefully when making comparisons between businesses.
- Return on capital employed (ROCE)
- Liquidity and solvency
- Current ratio:
- Current ratio = Current assets/Current liabilities
- Indicates whether a company can pay off its short-term bills by selling its current assets
- Normally, a ratio in excess of 1 should be expected. However, an ideal current ratio may be difference between industries
- Gearing:
- Gearing = Debt/(Debt + Equity)
- Higher gearing generally means higher risk as the company may not be able to pay all of its debts and goes bankrupt. Furthermore, higher debt indicates high interest expense which will undermine profit.
- Current ratio:
- Shareholder investment ratios
- Earning per share (EPS)
- EPS = Profit after tax/Total number of shares
- Measures how much money a company makes for each of its share and is a widely used metric for investors to compare between companies from the same industry
- P/E ratio:
- P/E = Share price/EPS
- A high P/E ratio implies strong shareholder confidence in the company’s future, i.e in profit growth, and vice versa
- Earning per share (EPS)