In today’s article, I am going to talk about the 7 Most Important Financial Ratios That Every Trader Should Know. Financial Ratios are the most important factors of the balance sheet of any company. Before going deep into this topic let us understand-
Financial Ratios are derived from the balance sheet of the company which represents the important information. Financial Ratios are used to do the Fundamental Analysis of the company.
Financial Ratios are used to simplify complicated things. There are a lot of factors that are present on the balance sheet of a company. It is impossible to analyze all these factors and compare them with others. Instead of this, a trader can simply compare two companies by using Financial Ratios to get a better investment opportunity.
Let’s take a look at some of the important financial ratios;
This is the most widely used Financial Ratio. PE Ratio is defined as the Current share price divided by earning per share. In short How many rupees you invest in that company to earn 1 rupee.
In mathematical terms,
A high PE Ratio indicates that traders are expecting high earnings growth from the company in the near future. Lower PE indicates that the company is undervalued. In general, if you are looking for value stock then a low PE ratio is preferred. However, every sector has different PE ratios. You can’t compare metal sector stock PE with IT sector stock PE. It is a totally illogical comparison.
It is the most basic and most Financial Ratio. EPS is defined as the profit of the company per outstanding share. EPS can be calculated in 2 ways-
Higher EPS indicates that the return on a single share is high. From the trader’s point of view, it is always good to invest in a company which is having higher and growing EPS. Before investing in any company for the long term, you should always check that company’s EPS for the last 5 years. If it is continuously growing then it is a good company to invest in otherwise you can search for better options.
The Price to Book Value Ratio or Price to Book Ratio gives the relation between a company’s current value and its book value. Book value is the value of all assets owned by the company.
Formula for P/B ratio = Market capitalisation / book value.
This ratio helps inventors to recognize undervalued companies. Generally, a PB ratio below 1 indicates an undervalued company but PB less than 1 also indicates that there are some other problems with the company because of which it is not showing earnings. So, traders need to look at the other parameters of the company as well. Also, many traders and financial analysts consider any value under 3.0 as a good PB ratio.
The debt-to-Equity ratio also called as Risk Ratio used to calculate total debt and liabilities against shareholders’ equity. If the debt-to-equity ratio is less than one, then your investment in that company is less risky than the company with a high Debt-to-Equity ratio.
A company which is having a Debt-to-Equity ratio of more than one is using more leverage to run its business operations. That is why the risk is more and one should review their investment before investing in such types of companies.
This is the most important ratio when it comes to the profitability of the company. It is calculated by dividing net income by shareholders’ equity.
In mathematical terms,
If ROE is more, it represents the company is earning more profit from its operations. In this way, ROE is one of the parameters to determine the profitability of the company. As a thumb rule, always look for the companies which are having ROE higher than 20%.
A stock dividend yield can be calculated by the company’s annual cash dividend per year by the current price of the share. Dividend Yield is represented in a percentage. This ratio estimates how much a trader can make through dividends by investing in that company.
The formula for Dividend Yield is,
This ratio is calculated to get an idea about the liquidity or current working capital of the company. This ratio is obtained by dividing current assets by current assets.
This ratio also shows that How to prepare the company is to meet its short-term obligations with short-term assets. A current ratio less than one is generally considered a bad current ratio.
I hope in today’s article, I was able to explain to you different financial ratios that every beginner should know before investing in a particular company. If you want to know more about the basics of the stock market then do check out our previous blog of the series, “Best Beginner’s Guide to the Stock Market | Module 2 | All About Stock Market Indices”. Also, if you have any doubt regarding this concept then, please post it in the comment section
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