Spend Some Time to Learn These Basic Financial Ratios
By: Barron Boon
If you want to enjoy financial independence and make good preparation for your retirement age, you have to learn how to invest responsibly. Wealth creation and wealth preservation are the key engines to achieve financial stability. Most of the new investors give more importance to the wealth creation/accumulation and completely overlook wealth preservation.
By making responsible future investments, you can easily achieve your wealth preservation targets as investments encourage asset growth in a sustainable manner. There are a number of ways in which you can make responsible investments to secure your future. You can invest in fixed deposits (1-2% returns/annum), in corporate bonds, real estate portfolios, stocks and shares and investment-linked policies.
According to a recent BlackRock Global Investor Pulse Survey, Singaporeans rely too heavily on cash holdings in their investment portfolios. A typical investment portfolio for an average Singaporean investor comprises of Cash Holdings – 48%, Equities – 18%, Property – 8%, Bonds – 5%, and Other Alternatives – 3%.
Important Terms to Know Before Learning the 4 Important Financial Ratios
If you are a novice investor, you need to familiarize yourself with the concepts of liquidity and barriers to entry before learning these 4 important financial ratios. Let us have a look at what these terms mean and how they can impact your business.
Liquidity refers to your ability to convert your stocks into cash when the need arises. There are some stocks that can be converted into cash without any hardships and within least period of time, whereas others may require a lot of time and can prove to be more challenging. Say, for example, a stock investor will find it easy to sell his/her stocks purchased today within a week’s time. On the other hand, an investor who has invested in private property will find it hard to sell the property within a short period of time.
Barriers to Entry
When considering an investment option, you may be faced to fulfill certain prerequisites. For example, if you are considering making an investment in real estate sector, you may be required to have at least 10-20% down payment to make an entry. On the other hand, you do not need to have such high down payments to invest in the stocks and bonds. These initial outlays when making an investment are termed as Barriers to Entry. The Barriers to Entry play an important role in encouraging or discouraging an investor to use a particular investment option.
While Barriers to Entry and Liquidity are the two most important concepts that you need to learn before looking at the 4 most important financial ratios, you cannot overlook the importance of research. Most of the novice investors listen to and follow the expert advice from their brokers or friends blindly. This type of attitude may not always promise good results. Besides listening to the expert advice from your broker or friend, you should also consider doing your own research. This way you will be able to make better decisions.
Now that you have a good understanding of a few basic financial concepts, let us have a look at the 4 important financial ratios and how they can help you make better investment decisions and check the overall health of your company.
- Revenue Growth
The first important financial ratio every investor should know about is the Revenue growth ratio. This ratio shows whether the company has been growing at a decent rate over the years. As an investor, you should target a company that has been growing at a rate of 5 percent per annum over the last three to five years.
By going through company’s annual reports and by looking at industry or mainstream media publications, you will be able to get a pretty good idea about the annual growth rate. You can also use this data to predict the revenue potential of the company and how would it perform in the coming years.
- Net Profit Margin
Another important financial ratio every investor should know about is the Net Profit Margin of the company. You can calculate this ratio by deducting operating expenses, taxes, interest, and preferred stock dividends from the total revenue. The net profit margin actually shows the percentage of the revenue the company generates after deducting all these expenses.
If you want to be on the safe side, look for companies that enjoy net profit margins of 10% and above. However, businesses with 7% or above net profit margin are considered to be in the safe zone.
- Return On Equity (ROE)
The third most important financial ratio that every investor should know about is the ROE or return on equity ratio. This ratio represents how many dollars of profit you will be able to generate from the company for each dollar invested. In other words, ROE reveals how much profit a company generates with all the money shareholders have invested in it.
A higher ROE ratio means a better performance by the company and vice versa. Look for companies that have a ROE ratio of 15% or above, as it is considered a good percentage.
- Debt-to-Equity (D/E) Ratio
The last most important financial ratio that the investors should keep in mind before making any investment decision is the Debt-to-Equity ratio. This ratio is a reflection of the debt used to finance a company’s assets and the relative proportion of shareholder’s equity. You can get this figure by dividing company’s total liabilities by the stockholders’ equity.
If you are an investor, you need to look for companies with D/E ratio of 0.5/1 or even lower, as the lower D/E ratio represents a lesser debt a company is saddled with.
Although there are a number of other aspects as well as financial ratios that you need to keep in mind before commencing a journey in investing, these 4 financial ratios are considered a benchmark while evaluating an investment venture.