How to Interpret Ratios Before Investing In Stocks
How to Interpret Ratios Before Investing In Stocks
by Christina Fernandez
Before you invest in some stocks or funds it is important to obtain knowledge about the company you wish to invest in and their financial stability. Many people may do some research about the company but may not know what each ratio represents. Here is an explanation of the six basic financial ratios:
1. Working Capital Ratio- This ratio measures the company’s liquidity. In other words, it measures how easily the company can convert their assets into cash in order to pay short-term obligations. This ration is calculated by dividing the current assets by the current liabilities. The assets should be higher than the liabilities. A 2:1 ratio is a good working capital ratio because its assets are higher than the liabilities. Also, put into consideration that the more cash among the assets a company has, the easier it helps them pay off their debts. Two companies can have the same ratio but one may have more cash among assets which makes them better off.
2. Quick Ratio- This ratio subtracts inventories from the current assets and then divides that by the liabilities. This is an important ratio because a company can have a large amount of assets but if the amount they have to pay for inventory exceeds their assets, then they are in debt. The principle behind the quick ratio is to determine how well current liabilities are covered by cash and by items necessary to run the company. A good quick ratio would be at least a 1:1; however a ratio less than this can also be acceptable because it means that the company can turn their inventories over into cash quickly.
3. Earnings Per Share- aka EPS, The earnings per share measures the net income earned on each share of a company’s stock. This is determined by dividing the net income by the number of common shares during a year. This will help you see the growth and financial health of the company.
4. Price-Earnings Ratio- aka P/E; This ratio is determined by dividing the share price of the company’s stock by the earnings per share. If the ratio is high, it means that investors are paying more for each unit of net income and the stock is more expensive. It measures how much investors are willing to pay for every dollar of earnings. For example, if a company was trading a P/E of 20, that means that investors are willing to pay $20 for every $1of earnings.
5. Debt-Equity Ratio- this ratio is determined by adding long and short-term debt and dividing it by the book value of the shareholder’s equity. It measures what proportion of equity and debt the company is using to finance its assets. Each industry has different benchmarks for what is a good ratio or a bad ratio. For example, auto manufacturing usually have a ratio about 2; however, personal computer companies have a ratio of under 0.5
6. Return on Equity- this is the ratio is determined by subtracting the preferred dividends by the net earnings and dividing that by the common equity. The higher the return on equity, the better the company is. This ratio helps investors decide how much profit they would earn when they invest in that company.
