The Importance of Financial Ratios

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As an investor, you always want to choose the best picks by looking at different financial ratios. Financial ratios are ways to convert the raw data of financial statements into information that can help you analyze the information. 

It is a cornerstone for fundamental analysis to analyze and compare a company’s financial ratios. The ratios provide insights into a company’s liquidity, operational efficiency, and profitability by studying its financial statements.

In general, you want to invest in companies with a high profitability and low-risk exposure at a fair price. So we will look into 4 types of financial ratios

  1. Profitability ratios to measure the company profitability 
  2. Liquidity ratios to measure the company’s short-term risk exposure
  3. Leverage ratios to measure the company’s long-term risk exposure
  4. Valuation ratios to estimate the fair share price of the company

Profitability Ratios

Profitability ratios indicate the company’s efficiency in generating steady profits.

Net Profit margin

Net Profit margin is one of the most widely used ratios. It compares the company’s net income to its revenue. A profit margin of 80%, means that for each EGP 100 the company generates in revenues, EGP 80 are profits. In general a higher profit margin is better, and most companies strive to improve its profit margin.

Return on Equity

Return on equity (ROE), is a key profitability metric that measures the company’s profitability in relation to the shareholders equity. In other words, it measures the company’s efficiency in generating profits for the shareholders.

Liquidity Ratios

Liquidity ratios are financial metrics that indicates the company’s ability to cover its short-term debt. Lower liquidity ratios might indicate that the company is at a risk of distress, which means that the company might have a high short-term risk. There are three major liquidity ratios, Current ratio, Quick ratio & Cash ratio.

Leverage Ratios

Leverage ratios indicate the company’s risk exposure in the long-term as opposed to the liquidity ratios that indicate the company’s risk exposure in the short-term. 

There are multiple leverage ratios, but one of the most important metrics is debt-to-equity ratio. It displays the capital structure of the company, whether it’s more oriented toward equity financing or debt financing. Debt-to-equity indicates the potential return on equity and the potential risk of bankruptcy due to default.

Valuation Ratios

You could find two spectacular companies with solid profitability & acceptable risk, however one can be overvalued and more expensive than the other. Here comes the role of valuation ratios, to see if the share price is fair or worth.

One of the most common relative valuation ratios used is Price to Earning ratio known as P/E ratio.

Price to Earnings Ratio

Price to Earnings (P/E) ratio helps investors to know the share market value compared to its earnings. It represents how much investors are willing to pay for each EGP 1 of income. A P/E ratio of 15, means that investors are willing to pay EGP 15 to get 1 EGP of profits.  To know more about P/E ratio, read our article here

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