Top 5 Fundamental Analysis Ratios
Fundamental analysis is used to determine a company’s financial health, performance and value for investing purposes. It can be done through studying the firm’s income statement, balance sheet, cash flow statement, management data and other key information. Below are some popular and widely used metrics to determine whether a company is worth investing in or not:
Return on Equity
Return on equity (ROE) is the ratio of net income to shareholder equity. It is a general indicator of how efficient a company is handling the money contributed by shareholders. A firm’s ROE can also be used for comparison against its peers, with a higher ROE signifying higher income generation with new investment dollars.
Gross Margin Ratio
A firm’s gross margin ratio is the gross profit (total revenue minus cost of goods sold) divided by its total revenue. It shows how much gross profit a company makes (in terms of percentage of revenue) after paying off its cost of goods sold (COGS). By monitoring this ratio, investors can determine whether the firm can operate at a sustainable level with its current COGS.
Price to Earnings Ratio
Price to earnings (PE) ratio is the most widely used ratio for stock valuation and to determine whether a company is “cheap” based on its share price and earnings. It is measured by the share price of a company relative to its earnings per share (EPS). By using EPS as the denominator, the value of the company is normalised by its earnings, which can be compared with PE ratios of other companies to assess whether the stock price is undervalued/overvalued based on its earnings.
Debt to Equity Ratio
Usually referred to as the leverage ratio, it is the proportion of debt that a company has compared to its equity. Leverage is important for companies that require large capital expenditures or companies focusing on expansion and growth. However, a high leverage ratio could also be dangerous as having a capital structure that is heavily skewed to debt would put pressure on the ability of the firm to repay its debt through cash.
Cash to Current Liabilities Ratio
Also known as the cash ratio, it measures the capacity of a firm to pay off its current liabilities. This ratio generally provides information on whether a company can cover its short-term obligations with the current cash position, its most liquid asset. A consistently low cash ratio can provide warning signs on the sustainability of the company’s health and performance.
A thorough and methodical fundamental analysis starts with understanding the key drivers behind a company’s future performance and the ratios provided above are powerful tools to help with that. It is important to note that these ratios are not fool-proof indicators and should not be used in isolation to determine the financial strength of a business.