10 Financial Ratios Every Beginner Investor Should Know

For the newbie investor, figuring out what to do with your money can be a scary and intimidating thing. And once you do figure out which companies you want to invest in, there’s the inevitable task of poring over those companies’ financial statements. Financial ratios, however, can help make sense of all that monetary jargon. Knowing what small bits of information to pick out, and how to interpret the data found, from convoluted financial statements is an important tool all investors should know. Here are 10 commonly used financial ratios that should be a part of every beginner investor’s research method.

1. Current Ratio (current assets / current liabilities)

The current ratio is used to test a company’s liquidity as well as to determine if a company’s short-term assets can pay off its short-term liabilities. So, a ratio over 1.0 means the business has more assets than debts, but if the opposite is true, and its ratio is under 1.0, the business is more vulnerable to economic swings.

2. Debt-to-Capital Ratio (fraction of debt / long-term capitalization)

Expressed as a percentage, the debt-to-capital ratio shows how a company finances its business operations, i.e. what percentage is financed through shareholder equity or debt. A higher number means a company has more debt compared to its capital structure, and a ratio under 40% is generally considered to be good. Just be aware that this ratio can vary widely from industry to industry. 

3. Debt-to-Equity Ratio (total liabilities / shareholder’s equity)

The debt-to-equity ratio is a measurement of how much suppliers, lenders, creditors, and obligors have committed to the company versus what the shareholders have committed. While it is not a pure measurement of a company’s debt, it is mainly used to help determine a company’s financial health. A lower number means a company has a stronger equity position.

4. Dividend Payout Ratio (dividends per common share / earnings per share)

The dividend payout ratio is an indicator of how much cash will go out in the form of dividends. It is also an indicator of how well a company’s earnings support its dividend payments. This ratio will vary by company, as many publicly traded businesses set their own dividend policy according to what they think best for shareholders.

5. Net Margin (net income / sales)

The net margin calculates how much of a company’s total sales trickle down to its bottom line. A higher margin is considered good, as it is better for shareholders. For example, if a company's net margin is 15%, that means its net income (or profit) is 15 cents for every $1 of sales the company makes. Margins will vary across industries, as different margin rates are considered good in different industries.

6. PEG Ratio (price to earnings ratio / projected annual growth in earnings per share)

Using the basic format of the P/E ratio (which is discussed in-depth below), the PEG ratio essentially compares a company’s P/E ratio to its growth rate, taking into account its future earnings growth. So, a PEG ratio of 1 or less is considered good (at par or undervalued to its growth rate) while a value greater than 1, in general, is not as good (overvalued to its growth rate).

7. Price-to-Book Ratio (price per share / book value per share)

The price-to-book ratio is used by investors to determine how a company’s stock price compares to its intrinsic value.(Note that book value is defined as total assets minus liabilities, preferred stocks, and intangible assets). This ratio will fluctuate depending on industry. Think of it this way: a P/B of 1 means a company’s stock is selling at its per share book value while a P/B of 2 means it's selling at 2 times its book value, and a P/B of 0.5 means its selling at half its book value.

8. Price-to-Cash Flow Ratio (price per share / cash flow per share)

The price-to-cash flow ratio is a good way to gauge whether a company is undervalued or overvalued. With this ratio, a lower number is generally considered to be good. It’s important to note that the net income of the cash flow denominator rightly adds depreciation and amortization back in since these are not cash expenditures; this aspect makes the ratio popular among investors.

9. Price-to-Earnings Ratio (price per share / earnings per share)

The price-to-earnings ratio is one of the most commonly used metrics for determining a company’s value relative to its earnings. A general rule of thumb is that shares trading at a low P/E ratio are a value, but what “low” means will vary by industry.

10. Price-to-sales Ratio (price per share / annual sales per share)

The price-to-sales ratio is a fantastic tool for investors because sales figures are considered to be relatively reliable; other income statement items, like earnings, for example, can be easily manipulated due to different rules. In general, the lower the number the better: if the P/S ratio is 1, that means you're paying $1 for every $1 of sales the company makes, and if a P/S ratio of 2 means you're paying $2 for every $1 of sales the company makes.