What are the key financial ratios used in fundamental analysis?

When performing fundamental analysis on stocks, key financial ratios are like a shortcut to understanding a company’s financial health. These ratios help you quickly assess a company’s performance and potential. By comparing these ratios with industry averages, you can determine if a stock is a good investment. Let’s take a look at the most important financial ratios every beginner should know.

1. Price-to-Earnings (P/E) Ratio

The P/E ratio is one of the most commonly used ratios. It tells you how much you are paying for each rupee of earnings. A low P/E might suggest that a stock is undervalued, while a high P/E could indicate overvaluation. However, it's important to compare the P/E ratio of a company to its industry average, as some sectors (like tech) tend to have higher P/E ratios.

Formula: P/E = Market Price per Share / Earnings per Share (EPS)

2. Return on Equity (ROE)

Return on Equity (ROE) measures how efficiently a company uses shareholders' equity to generate profits. A higher ROE means the company is effectively using its resources to make money for investors. As a general rule, a ROE above 15% is considered strong.

Formula: ROE = Net Income / Shareholders' Equity

3. Debt-to-Equity Ratio

The Debt-to-Equity (D/E) Ratio tells you how much debt a company is using to finance its operations compared to its equity. A higher D/E ratio indicates more debt, which can be risky if the company doesn’t generate enough income to cover its liabilities. As a general rule, a D/E ratio below 1 is considered safe.

Formula: D/E Ratio = Total Debt / Shareholders' Equity

4. Current Ratio

The Current Ratio measures a company’s ability to pay off its short-term liabilities with its short-term assets. A ratio above 1 indicates that the company can cover its current debts. A ratio too low (below 1) could indicate financial trouble.

Formula: Current Ratio = Current Assets / Current Liabilities

5. Earnings Per Share (EPS)

Earnings Per Share (EPS) is an important indicator of a company's profitability. It tells you how much profit a company makes for each share of stock. A higher EPS is usually better, as it shows that the company is making more money for its shareholders.

Formula: EPS = Net Income / Outstanding Shares

6. Final Thoughts

By understanding these key financial ratios, you can quickly evaluate the financial health of a company and make better investment decisions. Each ratio gives you a different perspective, whether it’s how profitable a company is (EPS), how much debt it has (D/E Ratio), or how efficiently it is using its equity (ROE).

Remember, no single ratio can give you the full picture, so it's important to look at them together for a more complete analysis. The more you practice analyzing these ratios, the more confident you will feel in making investment choices.