How To Use Financial Ratios For Investment Decisions

Have you ever heard of EPS or book value? Or maybe you have come across the acronyms ROI, ROA and ROE? These are all financial ratios that help you evaluate any given company’s performance. Here’s how to use financial ratios to make investment decisions.

What are financial ratios

Companies are unique and complex entities, with a lot of moving parts, financially speaking.

This makes it really hard to evaluate performance overtime and compared to other companies, within or outside of the sector the company operates in.

Financial ratios aim to make the comparison easier, bringing in more universal methods and benchmarks for it.

There are many financial ratios, and they evaluate things like debt levels, liquidity, returns, profitability and value among other things.

Different industries have their own benchmarks for ideal ratios in each category which is a valuable comparison tool.

Financial ratios are calculated by using companies’ financial statements, and information found in there.

There’s four financial statements that publicly traded companies need to provide regularly for everyone to read and these are the balance sheet, income statement (also known as profit and loss), cash flow statement and changes in capital and equity.

Where are financial ratios used

Financial ratios are used internally and externally.

Internally means that they are used within the company to monitor performance and compare it to previous years/time period and to other’s in the industry.

This can help with financial decision making and understanding where the company could improve.

Externally it can be used by creditors for example to decide if they will give out loans to the company and also by investors to help with investment decision making.

The ratios can give investors a very comprehensive look into the financial wellbeing of the company which can really help with making a decision on buying or selling the company shares.

Common ratios used for investment decisions

Fundamental analysis for example uses ratios as one of the decision making tools.

As mentioned above, there are many different ratios you can use, such as:

Liquidity ratios, for example current ratio which looks at how much current assets (like cash) the company has compared to how much short term debt they have. This is an indication of how well the company is able to pay for their debts.

Efficiency ratios, for example inventory turnover and receivables turnover, which tell you how quickly the company goes through inventory and how quickly they collect invoices from their customers, respectively. As the name suggests, these tell how efficiently the company is managing payments and inventory.

Profitability ratios, for example profit margin and return on assets (ROA). Profit margin tells you what percentage of your sales is profit and ROA tells you how much return the company is getting from their assets, or how efficiently the assets are used to make a profit.

Leverage ratios, for example debt ratio and interest coverage ratio. Debt ratio tells you the percentage of a company’s overall assets that are financed with debt, whereas interest coverage ratio tells how well the company can cover interest charges on debts.

Market value ratios, for example earnings per share (EPS) and book value. The EPS shows how much profit per one share the company makes and book value shows the value of the company as it stands on the balance sheet. The market value ratios help investors, surprise surprise, value the company and to know whether to invest or not to invest.

This is by no means a comprehensive list of financial ratios, but just a few examples of what they measure.

Now that you know what the ratios measure in general, the following are commonly used by investors when evaluating companies:

• P/E ratio, or price-to-earnings, compares the share price to the companies earnings. This can show if the share is over- or undervalued
• Price-to-book value compares the company’s market value to book value, it can show how much the market values the company’s assets
• Debt-to-equity ratio shows how much of debt the company uses compared to equity (=shareholders)
• Operating profit margin, or OPM, shows the percentage of profits from operational revenue. This shows how profitably the company operates
• Price-to-earnings growth ratio, or PEG, uses the earlier P/E ratio but adjusts it for growth as quickly growing companies can have high P/E ratios possibly falsely indicating overvaluation
• Return on equity, or ROE, shows how much return shareholders get from the overall earnings
• Interest coverage ratio, shows how well the company can cover their interest expenses from operations
• Current ratio, shows how liquid the company is, or how well they can cover their short term liabilities
• Asset turnover ratio will show how well the company is using their assets to generate revenue
• Dividend yield shows the level of dividends the company pays out

A word on how to interpret financial ratios

Each ratio often has a recommended or an ideal value but this shouldn’t really be relied on on face-value.

The ratios are a tool to help interpret and compare data, so the overall picture needs to be taken into consideration before any conclusions can be drawn from any ratios alone.

Think of it like inspecting a house that you are about to buy.

You can’t just look at it from one angle. You need to walk around, look inside, look at structures and the section as a whole. And not just what is one the section but also where the section is to determine the value.

When looking at the ratios you need to compare them to past data, see what the trend is and also see how they measure against competitors and the industry standards.

Then consider other information you have that might affect ratios, one way or the other.

Financial ratios are not an exact science but when used as a tool to see the full picture, they can be very helpful in helping you understand the financial wellbeing of a company.

If you have any questions, don’t hesitate to leave them below!