7 most important financial ratios that traders need to know for wealth creation

Financial ratios are one of the essential tools for an investor to succeed in wealth creation through investing in the stock market. Analyzing the ratios can help decipher the financial data bits, which is a prerequisite for most traders.

A good market reader with the know-how of financial ratios will always be on the favourable side of the coin in most situations. These ratios can signify a company’s operational efficiency, profitability, debt repayment ability, and other factors.

Since the full assessment of the health of a company and its offered securities is a tedious process, financial ratios can aid in the proper scrutiny of the shares.

Anish Singh Thakur, CEO, Booming Bulls Academy helped us decode the seven most notable financial ratios which can help in investment minus the stress factor.

● Price To Earnings Ratio (PE Ratio)

The name itself is self-explanatory. The P/E ratio is the current price of the share to the earning that the company can get per share. This ratio is significant in terms of indication as to whether a company is overvalued or undervalued.

P/E = Share Price/Earnings per share

The higher the value of the ratio, the more chances of the company expecting higher earnings. A lower value would indicate that the company is undervalued. Lower PE ratios are generally preferred when looking for a value stock. As these ratios have different yardsticks for comparison throughout various industries, absolute values can’t be compared head-to-head.
 

● Earning Per Share (EPS)

Earnings per share or EPS is the most basic financial ratio that one can gauge. The value of EPS is often used to determine other financial ratios. It is defined as the net profit of a company in a given period divided by the enumerable outstanding shares. It can be calculated on an annual basis or quarterly basis.
There are generally two ways to calculate EPS.

Earnings Per Share: Net Income after Tax/Total Number of Outstanding Shares.

Weighted Earnings Per Share: (Net Income after Tax – Total Dividends)/Total Number of Outstanding Shares.

When deciding to invest, one should consider looking at the past EPS of the company. If it is growing over the years, it is safe to invest; otherwise, a stagnant EPS means the company is not the ideal place to put your money in.

● Price to book value ratio (PBV)

The Price to book value ratio represents the relationship between the current value of a company and its book value. The ratio represents the part of the present value investment that will be received by the investor if the company declares bankruptcy and all its assets are liquidated. Here, book value can be defined as the value of all the assets owned by a company.

Formula for P/B ratio = Market capitalisation / book value.

A PBV under three is generally considered to be a good rate when looking to invest. When the PBV is under 1, it translates to a company that is undervalued, and it can also mean there are some underlying issues in the company.

● Debt-to-Equity Ratio

The debt-to-Equity ratio is defined as the total debt and liabilities against the shareholder’s equity. It is also called the risk ratio. If a company has this ratio at less than one, then it is safe. A company with a weaker equity position would have a high Debt-to-Equity ratio. The golden rule here is that any company with more than 1 is risky to invest in.

● Return On Equity (ROE) 

Return on Equity is paramount to the profitability of a company. It is defined as the net income divided by the shareholder's equity. In simpler terms, ROE can tell how well a company can reward its shareholders for their investment.

Return on Equity = (Net Income)/(Average Stockholder Equity)

Year by year, ROE is a good indicator of growth. The trick here is to avoid companies with an ROE of less than 15%.

● Dividend Yield

Stock dividend yield can be defined as the company's annual cash dividend per share divided by the stock’s current price and is expressed in annual percentage.

Dividend Yield = (Dividend per Share)/(Price per Share)*100

Many companies on the verge of growth do not provide dividends but try to invest their income towards their growth. An investor can play the judge here, and one can invest in a low or a high dividend-yielding company. 

● Current Ratio

The current Ratio helps in the evaluation of a company’s liquidity. It tells us how easily a company can meet its short-term liabilities or payments. It is usually used when short-term investments are being considered. It is mathematically defined as

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Current Ratio = (Current Assets)/(Current Liabilities)

If the company’s current ratio is less than 1, then that company is vulnerable to investments. If the value is more than one, that conveys the company has more short-term assets than short-term liabilities and can be looked at as an avenue for wealth creation.

(Disclaimer: The views/suggestions/advice expressed here in this article are solely by investment experts. Zee Business suggests its readers to consult with their investment advisers before making any financial decision.)