5 Key Financial Ratios and What They Reveal
Businesses use a variety of financial ratios to evaluate their performance and make strategic decisions. Financial ratios provide insights into a company’s overall financial health, efficiency, and profitability. Investors and analysts need to understand the key financial ratios used by businesses to make informed investment decisions. Assessing a company’s financial ratios can give you a good idea of its overall financial health, efficiency, and profitability.
The term “financial ratios” can be intimidating to some people, but it simply refers to the relationship between two financial variables. For example, if a company offers HVAC financing, its total financing receivables would be one financial variable, and its total HVAC sales would be the other. The ratio of receivables to sales would be the financial ratio. There are many financial ratios that provide insights into a company’s overall financial health. This blog post will focus on five key ratios. So, let’s get into the article.
Working Captial Ratio
The working capital ratio measures a company’s short-term financial health. It indicates whether a company has enough resources to pay its short-term obligations. The working capital ratio calculates a company’s current assets by its current liabilities. A percentage greater than 1 means the company has more assets than liabilities, which is generally a good sign.
A ratio of less than one means the company has more liabilities than assets, which is usually not a good sign. Every company has different ideal working capital ratios, depending on its industry and business model. For example, a company that relies heavily on inventory might have a higher working capital ratio than a company that doesn’t count as much on the stock.
Operating Cash Flow Ratio
The operating cash flow ratio measures a company’s ability to generate cash flow from its operational activities. This ratio is important because it shows how well a company can generate cash flow to fund its operations. To calculate the operating cash flow ratio, divide the operational cash flow by the total revenue. A higher ratio indicates that a company is more efficient in generating cash flow from its operations.
With that said, a low ratio may not be necessarily bad if the company is investing its cash flow into long-term projects that will generate more cash flow in the future. For example, let’s say that a company has an operating cash flow of $1,000 and total revenue of $10,000. The company’s operating cash flow ratio would be 10%. For each dollar of income, the company generates 10 cents of cash flow from its operations.
Earning per share is a crucial ratio for publicly traded companies. This ratio measures the amount of net income earned by each share of common stock. To calculate EPS, divide the net income by the number of outstanding shares. When buying shares of stock, investors want to see a company that is profitable and growing. A higher EPS indicates that a company is more beneficial and growing faster.
For instance, if a company has a net income of $1 million and 10 million outstanding shares, its EPS would be $0.10. Generally speaking, a higher EPS is better for investors because it indicates that the company is more profitable and growing at a faster rate. When considering EPS, it is essential to compare it to the EPS of other companies in the same industry.
Price-to-Earnings Ratio (P/E)
The price-to-earnings ratio is a crucial ratio for publicly traded companies. It indicates how much investors will pay for each dollar of a company’s earnings. In general, a higher P/E percentage means that a company’s stock is more expensive relative to its earnings. For example, a company with a P/E ratio of 20 is typically considered more costly than a company with a P/E ratio of 15.
To calculate a company’s P/E ratio, divide its current stock price by its earnings per share (EPS). Whether in water treatment financing or another industry, a company with a higher P/E ratio relative to its peers may be more expensive.
Debt To Equity Ratio (D/E)
The debt to equity ratio measures a company’s financial leverage. It tells us how much debt a company uses to finance its operations and growth. A high debt to equity ratio indicates that a company is highly leveraged and may be at risk of defaulting on its debt obligations. A low debt to equity ratio means that a company has a strong financial position and is less likely to default on its debt obligations.
The debt to equity ratio calculates a company’s total liabilities by its shareholders’ equity. For instance, if a company has $100 in total liabilities and $50 in shareholders’ equity, its debt to equity ratio would be 2.0. However, if the same company had $200 in total liabilities and $100 in shareholders’ equity, its debt to equity ratio would be 2.0. With a debt to equity ratio of 2.0, the company uses twice as much debt to finance its operations as equity.