Understanding Financial Ratios

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If you're trying to learn how to invest in the stock market, then you've probably seen terms like P/E ratio and Leverage. These are financial ratios, and understanding what these financial ratios are telling you about a company can make a difference between picking a winning stock or a dog.

Financial Ratio Concepts

Before we begin our discussion of financial ratios, we need to lay out some ground rules concerning the use of these ratios. Whenever you're researching a stock, you're trying to understand exactly what the financial ratios are revealing about the company. Many times, financial ratios will vary by industry. Therefore, it's important to understand how a company is performing relative to its industry.

Additional Resources

On a higher level, it's important to understand how a company is performing relative to the entire market. That is why you'll often find financial ratios quoted alongside both an industry benchmark as well as a ratio for a market index such as the S&P 500.

Categories of Financial Ratios

Stock market analysts like to play with numbers, and this means we have many financial ratios to cover. To make learning these ratios easier, we're going to break them down into six different categories:

Growth Ratios
Price Ratios
Profitability Ratios
Ratios of Financial Condition
Investment Ratios
Management Efficiency Ratios

As we begin to define the typical financial ratios you might encounter in each of these categories, we will emphasize the ratios experts believe are some of the better indicators of a quality stock. The key financial ratios discussed will be in bold type.

Growth Ratios

Growth ratios, or growth rates, tell us just how fast a company is growing. The most important of these growth ratios include:

Sales (%) - Sales growth is normally stated in terms of a percentage growth from the prior year. Sales is the term used for operating revenues, so it's important to see the sales growth rate as high as possible.
Net Income (%) - Growth in net income is even more important than sales because net income tells the investor how much money is left over after all of the operating costs are subtracted from sales.
Dividends (%) - Dividend growth is a good indicator of the financial health of a company. Some companies do not pay stock dividends at all; rather they use these excess profits to reinvest money back into the company to accelerate growth. The change in Dividends (%) should not be negative. That is, once a dividend rate is established, a company needs to have a very good reason to decrease the dividend payout.

Price Ratios

Price ratios are financial ratios that normalize a stock's selling price against a measure of the profitability of the company. Price ratios include:

Price / Earnings Ratio - The price to earnings ratio, or P/E ratio, is the stock's price divided by the latest 12 months of earnings per share. The P/E ratio is an indicator of the premium the investor will be paying for a stock. It is also an indicator of future growth expectations. In general, the lower the P/E ratio, the better, because a high P/E ratio indicates payment of a premium for the stock's "potential" future earnings.
Price / Sales Ratio - The price to sales ratio is the stock's price divided by the latest 12 months worth of sales. This measure became popular during the dot com years, when companies showed no earnings or profits. For that reason, it is not a very useful measure in today's environment.
Price / Book Value Ratio - The price to book value ratio is the stock's price divided by the book value of the company. A company's book value is a measure of the amount by which assets exceed liabilities (in terms of shareholder's equity). The price / book value ratio rarely falls below 1.0.
Price / Cash Flow Ratio - The price to cash flow ratio is identical to the P/E ratio except that it removes non-cash expenses and other accounting adjustments such as depreciation from that measure.

Profitability Ratios

Profitability ratios, or profitability margins, are a good indicator of how efficient a company is operating. These measures are normally used to compare a company to its industry (as a benchmark), rather than the overall stock market, since the profitability of companies can vary greatly by industry.

Gross Margin (%) - The gross margin is a ratio of a company's operating revenue to sales. Operating revenue is the company's sales revenue minus the cost of good sold.
Pretax Margin (%) - Pretax margin is a ratio of the company's pretax profits divided by operating revenues.
Net Profit Margin (%) - The net profit margin is the ratio of net profits to sales. This is the best indicator of the company's efficiency because net profit takes into consideration all expenses of the company. Investors want the net profit margin to be as high as possible.

Ratios of Financial Condition

Evaluating the financial condition of a company consists of two related, but distinct, types of measures. The first has to do with how much money the company has borrowed relative to how much money is "invested" in a company. This concept is known as leverage.

The second measure of financial condition has to do with a company's ability to pay back its creditors in terms of interest payments. The following ratios of financial condition measure these two aspects of a company's financial health:

Debt / Equity Ratio - The debt / equity ratio is a measure of the long-term debt divided by the common stock equity. This financial ratio is a measure of leverage. The lower the debt to equity ratio, the less likely a company will be affected by a downturn in the economy.
Current Ratio - The current ratio is a measure of the company's current assets divided by current liabilities based on the most recent quarter. The current ratio is used to provide guidance on a company's immediate financial health and its ability to meet current obligations.
Quick Ratio - The quick ratio, or acid test, is the sum of cash and receivables divided by the total current liabilities from the most recent quarter. The quick ratio is another measure of a company's immediate financial condition.
Leverage Ratio - The leverage ratio is calculated by taking the total assets and dividing them by total stock equity. The leverage ratio gives us an indication of the company's leverage. For example, if the ratio is high, then assets far exceed stock equity (meaning the company has a lot of debt relative to equity), and the company is considered leveraged.
Interest Coverage - The interest coverage is the company's latest 12 months' earnings before interest and taxes (EBIT) divided by the latest 12 months' interest expense. Interest coverage tells us how easily a company can handle its debt service. The higher the interest coverage value, the easier it is for the company to pay back its debt.

Investment Ratios

This next set of financial ratios gives us a good indication of how efficiently the money invested in a company is providing a return to those investors.

Return on Equity - A company's return on equity ratio, or ROE, is calculated by taking the latest 12 months' net income divided by common stock equity. The return on equity ratio is perhaps the most widely used, and most valuable, measure of how well a company is performing for its shareholders. The higher the return on equity, the better.
Return on Capital - The return on capital, or ROC, is calculated by taking the latest 12-months' net income divided by invested capital. Invested capital is defined as long term debt plus common stock and preferred equity.
Return on Assets - The return on assets ratio, or ROA, is determined by taking net income and dividing it by total assets. The measure is used to get a feel for how well a company is using their assets to generate earnings.

Management Efficiency Ratios

This last category of financial ratios is unique in that we would not consider any of these ratios as a primary driver of a stock's quality. That being said, it is important to understand exactly what these ratios are telling the investor:

Revenue per Employee - The revenue per employee ratio is calculated by taking revenues and dividing them by the total employees of a company. The revenue per employee ratio gives us a feel for the labor intensity of a business.
Receivables Turnover Ratio - The receivables turnover ratio tells us how many times accounts receivable have been collected in a given accounting period. Receivables turnover is calculated by taking the last 12 months of sales and dividing by the average receivables from the latest two quarters.
Inventory Turnover Ratio - The inventory turnover ratio is determined by taking the cost of sales for the latest 12 months and dividing by the company's average inventory. The resulting inventory turnover ratio tells us how fast the company's products are moving on the marketplace. For the inventory turnover ratio, a higher number is better.
Assets Turnover - The ratio of sales to assets, or asset turnover ratio, tells us about the capital-intensity of a business, and how well it uses assets to produce revenue. Companies that require a large infrastructure in order to produce, or deliver their product, such as electric utilities, require a large asset base to generate sales.

Final Words on Financial Ratios

Now that you have a better understanding of what a financial ratio is telling you, we're going to eventually use these ratios to help us pick stocks using a stock screening tool. But we have two more lessons before we reach that point. Up next, we're going to discuss how to evaluate insider trading information.

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