Important financial ratios for a potential equity investor

Important financial ratios for a potential equity investor

Introduction

Financial ratios are numerical values obtained after comparing two components of a company’s financial statement. They are essential in analyzing the financial performance of the company. Are important to investors because they give them relevant information about the company’s financial position so that they can make a decision about whether to invest in the company or not. Shareholders use the ratios to understand how beneficial it is to buy shares from the company while the lenders are able to understand the creditworthiness of the company.  This paper addresses the five important ratios for an equity investor, bond investor, bank investment, and shareholder.

Important financial ratios for a potential equity investor

A potential equity investor should consider the return on equity, dividend yield, return on assets dividend payout ratio, and equity to debt. Return on equity shows how the firm rewards its investors; the investor can decide if the company is a good deal or not. For instance, if the firm has a net income of $100 000, and its ROE is 5%, then the investor knows that investors have 95% of the $100,000.  The return on assets tells the investor how good the company Is at making use of its funds, for instance, a company with 10,000 net income and has 10,000 assets means that the company is able to make 0.1 for every $1 of the asset. The investor will decide if he will invest in the company or not. The equity ratio debt is essential in showing the investor the stability of the company. If the ratio is high, then the company is stable, but if the debt is high, then the company is unstable. The dividend is also a way of compensating the stakeholder. The dividend yield shows a company is able to pay out dividends, therefore the higher the yield, the higher the dividends. The dividend payout ratio is the percentage of profits that the investors receive as dividends. Investors ought to keep their eyes open on the changes in the dividend policies to understand what they expect from the company’s profits.dividend payout ratio=dividend/net income.

Five important ratios for  a potential bond investor

A potential bond investor needs to be aware of the credit ratio, current ratio, quick ratio, debt to equity ratio, and interest coverage ratio. The current ratio shows the company’s ability to settle short-term liabilities with its short term assets. If the ratio is 1.0 and above te, the company can be able to pay the short term debts well enough. However, If the ratio is less than 1.0, the company is vulnerable to not being able to pay debts. Current ratio=current assets/current liabilities. The quick ratio also shows how the company is able to settle its short term liabilities. However, it backs out the inventory. It only considers the assets that can be used to settle debts today.

Quick ratio= current assets- inventory/ current liabilities. A credit ratio shows the company’s creditworthiness. Using this ratio, the investor is able to understand if lending the company either a long-term or short term loan is a risk or safe investment. The debt to equity ratio shows the amount of capital that the company has borrowed compared to what the company has contributed. If the debt to equity increases, then the company will be unable to settle its debt obligations and can be bankrupt. The interest coverage ratio shows how well the company will be able to pay the interest rates to its lenders. If the company cannot pay these interests, then it will be bankrupt. It’s calculated through interest coverage ratio= EBIT/ interest expense. If the ratio is 1.0 and below, then the bank is in trouble.

Important ratios for a potential bank investment

When considering to take a short term loan, the company has to consider the same ratios as those of a bond investor. These include the current ratio, quick ratio, debt to equity ratio, interest coverage, and debt to capital ratio. The current ratio measures the ability of the company to settle short term liabilities. The quick ratio shows the company’s ability to settle short term debts in the absence of the inventory. The interest coverage ratio is the ability of the company to pay the interest rates that come with the loans. The debt to capital ratio shows the percentage of the debt that forms the capital of the company. If the ratio is high, then the company is not legible for a loan. The bank needs to evaluate all these ratios that point towards the creditworthiness of the company.

Five important ratios for  potential stakeholder

The ratios that a stakeholder needs to consider are similar to those of an equity investor. The shareholder ough to consider dividend yield, return on equity, equity to debt ratio, and the profit margin. return on asset ratio. The dividend and dividend payout ratio shows the ability of the company to pay dividends to its stakeholders. The dividend is a percentage of profits that should be divided amongst the stakeholders. Therefore if the dividend is high, then the more the stakeholder will benefit. The return on assets shows how well the company is able to use its assets to make assets. When a company has a$10000 net income and has 1000 000 assets, the ROA is 10%. This shows that with 1 of assets, it can make $0.10 in profits. If the ROA is higher, then the profits are more. Return on assets=net income/average total assets

Return on equity shows how well the company rewards its stakeholders. A company with a higher ROE shows that it offers it, stakeholders, good profits. The profit margin shows how much the total company sales flow. And the average amount of profits =it makes. If a company has high profits, then the stakeholders benefit more because they get better shares and better dividends. Equity to debt ratio shows if the company is financed more on equity or debts. A company financed with more equity than debt is safe to invest in, but one that is financed more with debt than equity possess the threat of bankruptcy.

Article by Kaminski, Wetzel, Guan. (2004)

The researchers sought to investigate whether financial ratios can detect fraudulent financial reporting. According to the researchers, fraudulent financial reporting is a grave social and economic concern. The Treadway commission recommends that the auditing standards board require the use of analytical procedures to improve the detection of fraudulent financial reporting. The authors conducted an exploratory study to analyze if the financial ratios in fraudulent companies can differ from those from companies that are fraud-free. The fraudulent participant firms were identified by examining the SEC’s Accounting and Auditing Enforcement Releases issued between 1983 and 1999. The fraudulent forms were then matched with nonfraudulent firms on the basis of the firm size, time period, and industry. Using this matched pairs design, ratio analysis for a seven-year period as conducted on 21 ratios. 16 ratios out of 21 were found to be significant. However, only three of the ratios were actually significant for three time periods. Of the 16 ratios, only five were significant during the period prior to the fraud year. The authors used discriminant analysis to seek misclassifications and found that thee misclassifications for fraud firms ranged from 58% to 98%. The authors concluded that there was a limited ability for financial ratios to detect fraudulent financial reporting.