When it comes to trading stocks, analysing financial statements is one of the most important aspects of fundamental analysis.
However, not everyone has got an accounting degree and staring at the stack of pages with mind-numbing terms and numbers can be overwhelming for most investors.
Here’s where knowing a few important financial ratios will help you get a quick overview of the financial health of a company you are interested to invest in.There are quite a number of financial ratios one can look at which measures different aspects of a company’s financial health.
Some of these are liquidity ratios, profitability ratios, debt, cash flow indicators and investment valuation ratios.
As you can see, the terms may not even make sense to some of us!
So here’s a little help from us to get you started on some of what we think are the most important ratios you can look at before you buy a stock:
1) Price-Earnings Ratio (P/E)
This is one of the most important ratios when it comes to financial ratio analysis and you will often see it being mentioned by Stock Market analysts.
This number indicates how much an investor is willing to pay for $1 of the company’s future earnings.
Generally, you want to invest in a company with a low P/E ratio. It indicates that the company may be undervalued.
For example, a long-term P/E is at about 15.Formula for PE Ratio is: Price of the Stock/Earnings per share(EPS)
The Earnings Per Share (EPS) can be calculated dividing the company’s net earnings in the income statement by the number of common shares outstanding.
2) Price-to-Sales (P/S)
The P/S ratio can be derived by dividing the company’s stock price against its annual sales numbers.
Similar to the P/E ratio, it’s a metric that indicates how much investors are willing to pay for every dollar of the company’s sales.
Some people prefer using the P/S ratio than the P/E as they feel that sales are harder to manipulate than earnings.
3) Debt-to-Equity Ratio
For those who have some basic knowledge of accounting, you’d know that debt-to-equity ratio consists of liabilities+equity+assets.
The debt-to-equity ratio basically shows you how leveraged the company is, or how much of its assets are financed by debt.
An investor usually prefers a low number as we all know that having too much debt can be a problem for a company, especially during a downturn.
However, do note that industries that are more capital-intensive tend to have a higher debt-equity ratio. Generally, if the ratio is greater than 1, the majority of the assets are financed through debt.
4) Return on Equity (ROE)
This is a measure of how efficient the company is at reinvesting its earnings to generate additional earnings. It measures how much shareholders have earned for their investment in the company.
Generally speaking, financial analysts would probably consider a ratio between 15-20% as a representation that it’s an attractive level of investment.
Formula of ROE = Net Income/Shareholders’ Equity
When using this indicator, one needs to take into consideration that a high level of debt can artificially boost ROE.
This is because the more debt a company has, the lesser shareholders’ equity it has (as a percentage of total assets), translating to a higher ROE.
5) Dividend YieldSome investors prefer to buy a dividend-paying stock.
This is especially so for investors who want to take lesser risks with their capital. Investors who have a higher risk appetite will usually aim to buy more growth stocks as they the potential for larger capital gains but they normally have little to no dividend payment.
A stock’s dividend yield can be calculated by dividing the annual dividend per share by the stock price.
A stock’s dividend yield depends on the nature of a company’s business, its earnings, cash flow and dividend policy. REIT (Real Estate Investment Trust) stocks tend to payout attractive dividend yields.
If you’re an income investor, a stock’s dividend yield might be the most valuable indicator you would use.