Financial Ratios That Investors Need to Know

Adapted from The Motley Fool, here are five financial ratios to help be a better investor. 

Understanding financial ratios is important because it can tell you more about the financial health and trends of a company to help determine if it is a good investment. The following ratios are easy to calculate and the numbers can be found on financial statements that publicly traded companies release every quarter.

Earnings per share (EPS)

Earnings per share = (net income – dividends from preferred stock) / average outstanding shares

Tells you how much of a company’s earnings is allocated to each outstanding common share. The ratio shows how profitable a company can be from the shareholders’ point of view. In general, higher EPS can be a positive indicator that profits are growing.

Price-to-earnings (P/E) Ratio

P/E = stock price / earnings per share

It measures what an investor is expected to pay for a stock that will yield a $1 of the company’s future earnings. A high ratio can indicate an overpriced priced stock, while a low ratio could mean the stock price is low compared to the earnings per share.

Many factors can affect the P/E ratio and by itself does not represent the value of the stock. P/E varies across industries.

Dividend Yield

Dividend Yield = annual dividends per share / stock price

Shows how much a company pays out dividends relative to the stock price. Not all companies will pay out dividends or increase over time. It will depend on the particular company and what the Board of Directors want to do. Profits could be reinvested in the company to keep growing. In this case investors continue to hold or buy company stocks with the assumption that stock prices will increase, off setting the lack of dividends

Price-to-sales ratio

Price-to-sales = stock price / annual net sales per share

It is used to compare the company value against industry competitors. Each industry will have its own average.

Debt ratio

Debt ratio = total debt / total assets

It measures the amount of debt a company has relative to its assets. Basically, it helps to determine whether a company is able to pay all its debt obligations by selling all of its assets. The higher the ratio the more leveraged it is and more risk that it is not able to pay its debts. Again the ratio will depend on the company size, industry, life stage and must be compared with competitors to get a better understanding.