Before investing, investors use financial ratios to investigate a firm’s health. These metrics assist in the valuation of a firm and are an important tool for fundamental analysis. I’ll go through the ten most common financial ratios in this post.
- Price to Earnings Ratio
The price to earnings (P/E) ratio is the most widely used percentage for fundamental analysis. It shows how much investors are willing to invest in a stock based on past, present, and future profits.
P/E should be used for companies in similar industries or companies with similar characteristics. A company like Google will have a higher price-to-earnings ratio than a small, unknown company from the same industry because Google is expected to earn multiples of profits for years to come.
- Price to Book Ratio
The price to book value (P/B) shows how much investors are willing to pay for all of a company’s assets if all were to be sold right now. This ratio measures all assets because all of a company’s assets are included in the balance sheet where the P/B ratio is found.
According to Lantern by SoFi, the price to book value has two major limitations when used for fundamental analysis. The first is that all companies have different asset lives, so one should not compare companies with vastly different average lives in trying to determine which company is undervalued. The second is that all companies use different methods to value their inventories (FIFO, LIFO, etc.)
- Debt to Equity Ratio
The debt-to-equity ratio shows what proportion of all company assets are financed by debt, which is debt, and all long-term debt equivalents paid off over time. This ratio can help determine how risky a stock is because of all the interest payments that will be required.
An important note about all financial ratios is to compare companies in similar industries or companies with similar characteristics. Google, for example, would never have a debt-to-equity ratio close to zero because it has much older assets (20 years) than all other technology businesses, which typically have assets of 5-7 years.
- Price to Earnings Growth Ratio
The price to earnings growth (PEG) ratio is one of the most popular ratios for fundamental analysis. It is the P/E divided by the percentage growth rate in earnings per share over five years. Investors use this ratio to determine how expensive a stock is relative to its growth prospects.
A critical note about all financial ratios is that this ratio should only be used for companies in the same industry or with similar characteristics. The reason is that all companies have different levels of debt and operating margins, which affects the P/E ratio, so one should not compare apples to oranges when using this ratio.
- Return on Assets Ratio
The return on assets (ROA) calculates how much income a company generated relative to all of its assets during the reporting period. All of a company’s assets are included in the balance sheet, where all the information needed for this ratio is found.
The return on assets has one major limitation when used for fundamental analysis; all companies have different asset lives, so one should not compare companies with vastly different average lives in trying to determine which company is undervalued.
- Return on Equity Ratio
The return on equity (ROE) calculates how much income a company generated relative to all the common shareholders’ equity during the reporting period. All of a company’s common equity is found on the balance sheet, where all the information required for this ratio is found.
- Profit Margin
The profit margin is the percentage of all revenues that are left over after all costs and expenses have been subtracted. It can be calculated using either gross or net margin, which measures all profits relative to all sales revenue before taxes.
- Current Ratio
The current ratio calculates all current assets relative to all current liabilities. All of a company’s current assets and all of its short-term liabilities are found on the balance sheet, where all the required information is found for this ratio.
- Quick Ratio (Acid Test)
The acid test or quick ratio calculates all cash, cash equivalents, and short-term investments relative to all current liabilities. All of a company’s cash, all of its short-term investments, all of its accounts receivable, all of its inventories, all of its prepaid expenses are taken into account with this ratio.
- Asset Turnover Ratio
The asset turnover ratio calculates all revenue generated relative to all assets. All of a company’s revenues and all of its assets are taken into account in this ratio. Because all companies have different average lives for their various types of assets, all companies should not be compared using this ratio.
In conclusion, all ratios can be useful tools for investors, but all companies should not be compared to one another. All financial ratios should be used as a guide and all ratios must be compared within a company’s industry or with similar characteristics to avoid comparisons between apples and oranges.