Introduction
As a financial analyst, I rely heavily on financial ratios to evaluate companies. If you’re new to investing, learning a few key ratios can help you make smarter decisions and avoid beginner mistakes.
Let’s break down 5 essential financial ratios, what they mean, and how to use them—even if you’ve never opened a balance sheet before.
1. Price-to-Earnings Ratio (P/E)
Formula: Stock Price / Earnings Per Share (EPS)
This tells you how much investors are willing to pay for $1 of a company’s earnings.
✔️ Use it to compare companies within the same industry.
2. Debt-to-Equity Ratio (D/E)
Formula: Total Debt / Total Equity
This measures a company’s financial leverage. A high D/E ratio may indicate higher risk, especially during economic downturns.
✔️ Look for a balanced ratio. Too much debt = red flag.
3. Current Ratio
Formula: Current Assets / Current Liabilities
This shows a company’s ability to pay short-term obligations. A ratio above 1 is generally good.
✔️ Ideal for assessing liquidity and short-term health.
4. Return on Equity (ROE)
Formula: Net Income / Shareholder’s Equity
ROE measures how efficiently a company is generating profits from shareholders’ money.
✔️ Higher ROE = better efficiency.
5. Free Cash Flow (FCF)
Formula: Operating Cash Flow – Capital Expenditures
This tells you how much actual cash a company generates, which can be used for dividends, debt repayment, or reinvestment.
✔️ Cash is king. FCF reveals what earnings can sometimes hide.
Final Thoughts
Ratios aren’t just for Wall Street. They’re tools that help you see behind the curtain of a company’s financials. Learn them, use them, and watch your confidence grow.