Personal finance is not just about monitoring your expenses. It is also about knowing where your money goes and making sure you are able to save and invest for your future. Financial ratios are an effective way of measuring the financial health of an organization or individual. They help you understand how well a company manages its resources and whether it has sufficient capital to operate at peak performance. Financial ratios are simple calculations that enable users to see the relationship between different figures in a set of financial statements. They can be used with almost any type of financial data, from broad measures like balance sheet or cash flow statement, to specific items like depreciation expense or stockholder equity. Thanks to their simplicity, these ratios are easy to understand, and once you know them, they’ll be useful in analyzing the financial strength of potential investments as well as monitoring your own personal finances.
What Are Financial Ratios?
Financial ratios are a series of calculations that enable investors to determine how a company’s balance sheet and income statement are operating. Ideally, the ratios should be consistent year after year, indicating that the company is managing its resources well. If the ratios show a significant change, however, it could indicate that the company has been unable to meet its obligations and is therefore in a financially precarious situation. Financial ratios are also used to measure an individual’s financial health. For example, someone may have $50,000 in savings and $50,000 in debt. A financial ratio, such as the debt-to-equity ratio, might indicate that the individual is living beyond his means.
The debt-to-equity ratio measures the amount of a company’s total debt compared to its stockholder equity. It is calculated by dividing a company’s total liabilities by its stockholder equity. The resulting number indicates the percentage of debt a company has in relation to its equity. A higher debt-to-equity ratio indicates that a company has borrowed more money than it has put up in equity. In other words, it is heavily financed by debt instead of its owners’ equity. Companies that have a high debt-to-equity ratio face greater risk of default than do companies with a higher equity ratio. This is because when a company defaults on its debt, the lender takes ownership of the assets used as collateral.
Return on Equity (ROE)
Return on equity (ROE) is a measure of how effectively a company is using its stockholder equity to generate profit. It is calculated by taking net income and dividing it by stockholder equity. The higher the ROE, the more the company earns with each dollar invested by stockholders. A company that earns a high ROE is effectively managing its resources well, and a comparison of ROE over time can show how effectively management has managed to increase earnings despite inflation.
Net Income to Equity (Net-Equity) Ratio
The net-equity ratio is a variation of the ROE ratio, used primarily when a company is first starting out. It is calculated by dividing net income by stockholder equity. Like the ROE, the higher the net-equity ratio, the better. This indicates that a company is generating a profit with every dollar of stockholder equity it has. While a high net-equity ratio is desirable, it is not necessarily an indication that the company will remain profitable in the future.
Earnings-Per-Share (EPS) Ratio
The earnings-per-share (EPS) ratio measures the amount of profit a company has earned for each share of common stock. Rather than using net income or total assets, the profit metric used in the EPS ratio is net income. The higher the EPS, the more profitable each share is. This ratio is a good indication of how well the company is managing its assets. It is also a useful metric for comparing companies in the same industry.
Price-to-Earnings Ratio (PE Ratio)
The price-to-earnings (PE) ratio is the current market price of a share of a company’s stock divided by the amount of earnings per share. It is one of the most common ways to compare the earnings potential of stocks and find undervalued stocks. The PE ratio is calculated based on the company’s earnings over the past 12 months along with the current share price. The PE ratio is one of the most common ways to compare the earnings potential of stocks and find undervalued stocks. A lower PE ratio indicates that a stock is undervalued and may be a good investment opportunity.
The solvency margin is primarily used to determine the amount by which a company’s current assets exceed its current liabilities. It is calculated by subtracting the current liabilities from the amount of current assets. A company with a positive margin is in good financial standing and has more assets than it owes. A negative margin indicates the company is operating at a deficit.
The liquidity ratios measures a company’s ability to meet its short-term obligations. It is calculated by taking a company’s current assets and dividing them by its current liabilities. The higher the ratio, the better. A company with a positive ratio has more assets than it owes, which means it is financially sound. A company with a negative ratio is in debt, and a negative ratio of less than 1 indicates that it does not have enough cash on hand to meet its short-term obligations.
Financial ratios allow you to measure the financial health of a company. They also allow you to measure your financial health. By keeping track of your finances with an expense tracker and monitoring your financial ratios, you will be able to save more money and stay on track with your financial goals. That said, making sure you are using the right ratios for your situation is important. For example, if you own a business, you will want to use different metrics than someone who is investing in the stock market. With that in mind, having an understanding of the most common financial ratios will help you keep track of your finances and make smarter financial decisions.