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Home / Investing / Investing – Financial Ratio

Investing – Financial Ratio


To determine the liability of a company can be a lengthy and complex process. A quick way to narrow down the selection process would have to evaluate the financial strength of the company and the effectiveness of its management team.

The financial ratio of current ratio, debt-equity ratio, price-earning ratio (PER) and return on equity (ROE) is one quick way to check the status of a company.

Current Ratio

Current Ratio is an indicator of the company's debt-paying ability over the short term (12 months or less). It's determined by dividing the current assets by the current liabilities. If the income is between 1 and 2.5, the company's financial situation can be considered as healthy. Even tougher, the higher the ratio, the more liquid the company, however, anything over 2.5 would indicate that the company may be keeping too much cash and may not be investing enough to provide future growth.

It's probably also useful at this point to calculate the interest coverage ratio, which will indicate the company's ability to service its debt. Interest coverage ratio is income before interest and tax divided by the interest expense. The greater coverage, the better it is.

Debt-To-Equity Ratio

Debt-To-Equity Ratio is an indicator of a company's long term financial leverage. It compares the assets provided by the creditors with the assets provided by the shareholders of the company and is determined by dividing the long term debt by the shareholder's equity.

The track record of the management team can be determined by using the following ratios:

Price-Earnings-Ratio (PER)

The Price-Earnings-Ratio is the relationship between the market price of the company's shares and the earnings per share (EPS). This ratio tells you what you would be paying for each dollar of earnings. To work out the PER; divide the share price by the EPS. Typically, a high PER would mean high projected earnings in the future. However the PER actually does not tell us a whole lot by itself. It's useful to compare the PER of companies in the same industry, or to the market in general, or against the company's own historical PER.

As earnings tend to fluctuate from year to year, consider using the average earnings over the last six to ten years rather than for a particular year. It's more valuable to look at the PER over time in order to determine the trend.

Return On Equity (ROE)

The Return On Equity encompasses the three main areas where investors can assess the company's profitability, asset management and financial leverage. ROE represents the management's ability to balance these three poles of corporate management and investors will get a feel of whether they'll receive a reasonable return on equity and assessment the management's ability to perform.

ROE is determined by dividing net income by shareholders' equity. Net income is the last item listed on the income statement while shareholders' equity (the difference between total assets and total liabilities which is located in the balance sheet).

By working out these ratios, investors are able to form an evaluation of a company's financial strength, its management and employees. However, these ratios should only be used as a guide only. They should also be viewed in conjunction with each individual's objective.

For instance, if you were a value investor, you would consider a company with a PER of 30 to be too expensive. However, if you were going for growth, you would consider the company to be viable investment if it had an ROE of over 25 and its earnings were still growing rapidly.

Michael Russell

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