Tony taught Business and Aeronautics courses for eight years; he holds a Master's degree in Management and is completing a PhD in Organizational Psychology
Financial ratios are a quick way to review a company's financial performance and compare it with others. This lesson will review a few select financial ratios to show how they are developed and how they can be used to forecast future performance.
If you've ever looked at the financial section of a company's annual report or popular financial websites, you probably noticed a lot of acronyms like EPS, ROA, ROE, and P/E. Each of these is a different ratio that gives specific information about how the company is performing. They look at things like profitability, the use of assets, the ability to pay debts, or how well the company pays stockholders dividends. Depending on your investment strategy, you'll be concerned with different ratios. This lesson assumes that you already have a basic knowledge of terms found on common balance sheets and income statements.
It's important to note that these ratio values can vary widely depending on the industry and size of the company; they therefore have little meaning by themselves. In order for the ratio to provide you with valuable information for forecasting, you'll have to compare the ratio to something else, such as the same ratio for the same company in prior years or their competition's ratio during the same periods.
The type of industry is very important when looking at the value of a ratio. A service-related industry, such as a web-based search engine like Google or Yahoo, etc., will have a totally different amount and use of assets than a manufacturing company like Dell or Dodge. When you're using each ratio, there will be a specific range that usually applies to the given industry.
There are many other considerations to take into account, including different methods of accounting allowed under generally accepted accounting principles (GAAP), recent changes in company focus, changes in leadership, updates to tax laws, increase or decrease in competition, or corporate restructuring. Any of these will have a temporary impact on the company's ratios, so be sure to look for trends over multiple years and take other factors into account.
There are many profitability ratios, but the one we'll focus on here that is commonly used in forecasting is return on equity (ROE). ROE is found by taking the net income for the company and dividing it by the average stockholders' equity. The average stockholders' equity can be found by adding the stockholders' equity from the end of the current year and the beginning of the current year and dividing by two. This ratio provides investors and researchers with the amount of return (increase) that has been earned by using the stockholders' investments.
Let's give it a try. What would be the ROE of Profits, Inc., which began the year with $2.5M in shareholder equity, ended that year with $2.7M, and earned a net income for that period of $350,000?
ROE shows profit percentage made from investments:
Another common profitability ratio is return on assets (ROA). ROA attempts to analyze how well a company is using their assets to make profits. This ratio will show a big difference between a company that focuses their purchases on things that make the company (and investors) more money (such as equipment) as opposed to spending on things that may look good (like a fancy new office building) but do nothing to generate revenue. ROA is found by taking net income and dividing by average total assets. Average total assets can be found in the same way we used to find the average stockholders' equity in the ROE ratio.
Armed with this knowledge, what would be the ROA for Profits, Inc. if they had average total assets for the year of $3.1M?
ROA measures efficient use of assets:
Net income / Average total assets = $350,000 / $3,100,000 = 11.29%
Over 79,000 lessons in all major subjects
Get access risk-free for 30 days,
just create an account.
Another important ratio that investors look at to forecast future company performance is how an organization uses debt. Unlike profitability ratios, which are found by taking an average over a period of time, debt ratios are more of a 'snapshot' at one point in time. Debt can also be referred to as leverage because money is often borrowed in order to increase profits or to take advantage of discounts for larger purchasing quantities.
The ratio that we will examine for this section is, appropriately, called the debt ratio. The debt ratio is found by dividing total liabilities by total assets. Profits, Inc. has total assets of $3.1M and total liabilities of $1.2M. What is their debt ratio?
Debt ratio shows use of leverage:
Total liabilities / Total assets = $1,200,000 / $3,100,000 = 38.71%
There are many more investment ratios than we could possibly describe in one lesson, so today we'll discuss the most popular ratio in this category: the price per earnings ratio (P/E ratio). The P/E ratio is found by dividing the current stock price by the earnings per share (EPS). Earnings per share is found by taking net income and dividing by the average number of outstanding shares.
In this case, Profits, Inc. has 75,000 shares of stock outstanding, selling for a price of $80.00 per share. The computations show how to compute the P/E ratio:
Profits, Inc. earned $4.67 for every share of stock ($350,000 net income divided by 75,000 shares of stock). The result of the P/E ratio is not a percentage, but it shows that for each dollar of income that Profits, Inc. generated last year, investors are willing to pay $17.14. The higher the P/E ratio, the more confidence that investors have in a company's future earnings. P/E ratios typically range from about 15 to 25.
Financial ratios can be used to help forecast how a company will perform in the future. Of course, there are no guarantees as to what will happen, but investors use these ratios to measure companies against their own history or compare them with their competitors.
Profitability ratios show how much income a company makes as compared to different aspects of the company, such as average stockholder equity (for ROE) or average total assets (ROA). Debt ratios compute how well a company is using debt to make a profit (leveraging). The P/E ratio is the most common investment ratio and shows the amount of confidence that investors have in a company's ability to generate future earnings.
Did you know… We have over 200 college
courses that prepare you to earn
credit by exam that is accepted by over 1,500 colleges and universities. You can test out of the
first two years of college and save thousands off your degree. Anyone can earn
credit-by-exam regardless of age or education level.