Finance and economics are intricately tied to numerical data derived from complex computations and formulas. These numbers, however, serve as a powerful window into a company’s financial health and the effectiveness of its current strategies. Enter financial ratios – these calculations are the compass that guides traders and investors, offering insights into the profitability and potential success of their endeavours.
Financial ratios hold a pivotal role in decision-making and the formulation of sound investment strategies. In this article, we delve into the world of financial ratios, understanding their importance and exploring some key ratios that every investor should be acquainted with.
Disclosure of Financial Ratios
Financial ratios offer a quick snapshot of a company’s economic prospects without necessitating intricate calculations each time. They simplify the process, allowing you to assess the profitability of your investments and anticipate returns at a glance. These figures result from various calculations, often facilitated by software, calculators, or specialised devices, and they convey critical financial information.
Financial ratios are seamlessly integrated with various financial tools and statements, including balance sheets, income statements, cash flow analyses, feasibility assessments, etc. Moreover, they can unveil underlying issues or potential concerns that might not be apparent in standard financial reports or projections. Therefore, understanding the major financial ratios is imperative for anyone in the world of finance.
Key Financial Ratios for Your Arsenal
It’s essential to recognise that the landscape of financial ratios is dynamic, evolving to keep pace with the ever-changing business environment. Therefore, financial analysts need to stay updated with the latest developments. Nonetheless, several core ratios have stood the test of time and remain fundamentally relevant. Let’s explore some of these critical financial metrics:
1. Earnings Per Share (EPS) Ratio
Earnings per share is a pivotal ratio in the stock markets. Many companies rely on this metric to plan their public offerings, while investors use it to allocate their investments. The EPS ratio provides crucial insights into a company’s stock profitability and potential shareholder returns.
EPS can be calculated in two ways:
EPS = Company’s net income / Average outstanding shares.
EPS = (Company’s net income – Dividends to preferred shareholders) / Average outstanding shares.
Publicly traded firms aim to boost their EPS to attract more investors because a higher EPS translates to increased earnings for shareholders.
2. Working Capital Ratio (WCR)
Balancing assets and liabilities is a constant endeavour for corporations. The working capital ratio helps companies gauge how well their assets perform compared to their liabilities. It can be calculated as follows:
Working Capital Ratio = Current assets / Current liabilities.
A ratio of less than 1 suggests inefficient financial management and potential liquidity problems. In contrast, a WCR between 1.5 and 2 indicates financial stability, while a ratio above two may hint at inefficient asset management.
3. Return on Equity (ROE)
Investors hold the return on equity ratio in high regard, reflecting how effectively a company manages their invested capital. This is especially pertinent for startups that rely on funding from angel investors, accelerators, and funds. Once a business is operational, investors analyse the ROE to measure their equity growth. ROE is calculated as:
ROE = Net Income / Shareholder Equity.
In conclusion, financial ratios are indispensable tools for understanding a company’s financial position and monitoring investments. These ratios, derived from various measures, offer comprehensive insights that guide a company’s financial strategy. They play a central role in most financial statements and analyses, making it essential to understand their functioning and track them to uncover underlying financial trends and opportunities.
