Learning Objectives

After completing this chapter, you will be able to:

• Understand what financial ratios are.
• Learn why investors use financial ratios.
• Identify some of the most important financial ratios.
• Understand how financial ratios help compare companies.
• Learn the limitations of using financial ratios.
• Use financial ratios as part of your investment research.

Introduction

When researching a company, looking at its revenue or profit alone is not enough. Investors use financial ratios to better understand a company's performance, profitability, efficiency, and financial health.

Financial ratios make it easier to compare companies of different sizes and within the same industry. They are widely used by professional investors, analysts, and fund managers when evaluating investment opportunities.

What are Financial Ratios?

Financial ratios are calculations that use information from a company's financial statements to measure its performance.

They help investors answer questions such as:

• Is the company profitable?
• Is it financially healthy?
• Is it managing debt effectively?
• Is the company growing?
• Is the stock reasonably valued?

Financial ratios provide a simple way to compare businesses over time or against competitors.

Why are Financial Ratios Important?

Financial ratios help investors:

• Compare companies within the same industry.
• Measure business performance.
• Evaluate profitability.
• Assess financial strength.
• Identify business trends.
• Support investment decisions.

Rather than relying on one number, investors often analyse several ratios together.

Common Financial Ratios

Some of the most commonly used financial ratios include:

• Price-to-Earnings (P/E) Ratio
• Earnings Per Share (EPS)
• Return on Equity (ROE)
• Debt-to-Equity (D/E) Ratio
• Dividend Yield
• Current Ratio
• Price-to-Book (P/B) Ratio

Each ratio measures a different aspect of a company's financial performance.

Earnings Per Share (EPS)

EPS shows how much profit a company earns for each ordinary share.

It helps investors understand a company's profitability on a per-share basis.

Formula

EPS = Net Profit ÷ Number of Shares Outstanding

Companies with consistently growing EPS may indicate improving business performance.

Return on Equity (ROE)

Return on Equity (ROE) measures how effectively a company uses shareholders' money to generate profits.

Formula

ROE = Net Profit ÷ Shareholders' Equity × 100

Generally:

• Higher ROE may indicate efficient use of shareholders' funds.
• ROE should be compared with companies in the same industry.

Debt-to-Equity (D/E) Ratio

The Debt-to-Equity Ratio compares a company's debt with its shareholders' equity.

Formula

Debt-to-Equity Ratio = Total Debt ÷ Shareholders' Equity

Investors often use this ratio to assess financial risk.

Generally:

• Lower ratios may indicate lower financial leverage.
• Higher ratios may indicate greater reliance on borrowed money.

Acceptable debt levels vary across industries.

Current Ratio

The Current Ratio measures a company's ability to pay its short-term obligations.

Formula

Current Ratio = Current Assets ÷ Current Liabilities

Generally:

• A ratio above 1 may indicate the company has sufficient short-term assets to cover its current liabilities.
• A very low ratio may suggest liquidity challenges.

Dividend Yield

Dividend Yield measures the annual dividend income relative to the current share price.

Formula

Dividend Yield = Annual Dividend Per Share ÷ Share Price × 100

Dividend Yield helps income-focused investors compare dividend-paying companies.

However, investors should also consider whether the dividend is sustainable.

Price-to-Earnings (P/E) Ratio

The P/E Ratio compares a company's share price with its earnings.

It helps investors understand how much they are paying for each dollar of company earnings.

Higher or lower P/E Ratios should always be assessed within the context of the company's industry and growth prospects.

Price-to-Book (P/B) Ratio

The Price-to-Book Ratio compares a company's market value with its book value.

It is commonly used when evaluating:

• Banks
• Insurance companies
• Property businesses
• Asset-intensive companies

The P/B Ratio can help investors understand how the market values a company's net assets.

Reading a Real ASX Example

Let's look at a simplified example using CSL Limited (CSL).

When analysing CSL, investors may review:

• Earnings Per Share (EPS)
• Return on Equity (ROE)
• Debt-to-Equity Ratio
• Price-to-Earnings (P/E) Ratio
• Dividend Yield

By analysing several financial ratios together, investors can develop a more complete understanding of the company's financial performance.

Why Financial Ratios Should Be Used Together

No single financial ratio tells the complete story.

For example:

• EPS measures profitability.
• ROE measures how efficiently profits are generated.
• Debt-to-Equity measures financial risk.
• Current Ratio measures short-term financial strength.
• P/E Ratio helps assess valuation.
• Dividend Yield measures income potential.

Using several ratios together provides a more balanced view of a company's financial health.

Key Takeaways

• Financial ratios help investors evaluate a company's financial performance.
• Different ratios measure different aspects of a business.
• EPS measures profit earned per share.
• ROE measures how effectively shareholder funds are used.
• Debt-to-Equity assesses financial leverage.
• Current Ratio measures short-term liquidity.
• P/E and P/B Ratios help investors assess valuation.
• Investors should use multiple financial ratios together rather than relying on just one.