In order to evaluate a company’s financial health, there are some important ratios which will help investors get a clearer picture of companies.
Current Ratio – It is the current assets divided by the current liabilities in a company. This measures the ability of a company to pay current its liabilities over the next 12 months. Quick ratio should be at least more than 1. If its value is less than 1, it means that a company has insufficient cash to meet short term debts.
Current Ratio = Current Assets ÷ Current Liabilities
Quick Ratio – It can be known as an “Acid Test.” It is the current assets subtracted by the current stock and divided by the current liabilities in a company. This value indicates a company’s short term liquidity. It can tell a company if it has the ability to meet its short-term obligations with its most liquid assets.
Quick Ratio = (Current Assets – Stock in Inventory) ÷ Current Liabilities
Typically, a quick ratio should be more than 1 for strong financial companies. However, for an oil company, stock in a company is oil, which is a very high liquidity asset. It may be acceptable if the quick ratio is below 1.
Debt to Equity Ratio – There are several meanings to determine a debt to equity ratio (http://accounting-simplified.com/financial/ratio-analysis/debt-to-equity.html). In this topic, the debt to equity ratio is the total financial debt divided by the equity of a company.
Debt to Equity Ratio = Total Financial Debt ÷ Equity
It is the value showing how much a company utilizes a financial leverage. Debt financing often yields a good investment return because the cost of debt is cheaper than the cost of equity. Nevertheless, high debt to equity ratio increases risk of a company because a company has to pay high interest. If the conomic state goes down and/or an interest increases, a company with high debt will have a bad financial situation.
Debt to Ratio – It is a ratio of debt to total assets and it can be interpreted as the proportion of a company’s assets that are financed by debt. In this case, we will use total financial debt for this calculation.
Debt Ratio = Total Financial Debt ÷ Total Asset
Profit Margin – It is a ratio of profit to turnover (Sales). In a profit and loss account, there are 3 profits (Profit before interest and taxation (PBIT), Profit before tax, and Profit after Tax). The best figure to represent a company’s profit margin is Profit before interest and taxation (PBIT) because it directly reflects a business performance.
Profit Margin = Profit before interest and taxation (PBIT) ÷ Turnover (Sales)
Return on Asset (ROA) – This is a ratio of PBIT to total assets of a company and this value indicates the efficiency of a company to make a profit on a company’s assets.
Return on Asset (ROA) = Profit before interest and taxation (PBIT) ÷ Total Assets
Earnings Per Share (EPS) -This is a ratio of net earnings to total shares in a company.
Earnings Per Share (EPS) = Profit after Tax ÷ Total shares
Dividend Cover – it is a number showing how many times that a company can pay dividends to investors from the profits earned during an accounting period.
Dividend Cover = Earnings Per Share (EPS) ÷ Annual Dividend Per Share
Reference Book
Thomas Sowell (2007) Basic economics: A Common Sense Guide to the Economy, New York, New York, USA: Basic Books.