This summary of financial ratios is excerpted from Emerging Companies Guide: A Resource for Professionals and Entrepreneurs, Third Edition, edited by Alan S. Gutterman and Robert L. Brown. It provides a guide to key ratios for understanding financial statements, targeted at what founders of emerging companies and their legal advisers need to know. The summary covers liquidity ratios, cycle ratios, solvency ratios, profitability ratios, and equity ratios.
The equity ratios (also called market ratios) help to evaluate the company’s relationship with its stockholders (owners). Because the company’s common stockholders are its true owners, all these ratios are computed only with respect to the income accruing to and the equity belonging to the common stockholders. In this way, any preferred stock issued by the company is treated more like debt than equity.
The earnings per share and price to earnings ratios are probably the two equity ratios most often cited by financial analysts. Both must be evaluated with care. The computation of earnings per share (as shown in the chart) appears simple, but it is deceptively so. The actual computation of earnings per share (by publicly traded corporations) includes the dilutive effects, if any, of stock options, warrants, and rights and convertible bonds and preferred stock. This approach ensures a conservative measurement for calculating earnings per share, and actual earnings per share—if there is such a thing—could be larger by some unknown amount. Thus, earnings per share should be viewed as a conservative measure of stockholder returns and not be confused with an actual measure of those returns.
The price to earnings ratio is commonly viewed as a benchmark that reflects the market’s collective decision about the company’s future earnings power relative to that of other companies. From time to time, the P/E ratio may indeed reflect the market’s opinion about the company’s own future. That is, the company’s P/E ratio may be high (low) as compared to other companies because it has higher (lower) earnings potential than other companies. However, care must be taken to consider that the market’s opinion (as reflected by stock prices) may be incorrect. In a bull (bear) market all P/E ratios may be higher (lower) simply because the market is higher (lower). In such a market, while the company’s P/E ratio relative to other companies may be correct, the ratio may not well represent the actual value of the company’s future earnings. This can be particularly true in a bear market when all stock prices are depressed regardless of the company’s true earnings potential. P/E ratios also can be inflated (deflated) because of investor infatuation (disgust) with select companies and/or industry sectors—as both the dot com bubble at the end of the 1990s and housing bubble at the end of the 2000s attests.
Several of the equity ratios measure either the amount of company profitability paid out to stockholders (dividend payout ratio, dividend yield ratio) or the amount of profitability/cash flow kept by the company to support internal growth needs (retained earnings ratio, retained cash ratio). These ratios are of little importance for companies at both ends of the maturity spectrum. For companies in the middle ground, these ratios can provide useful information as company management attempts to balance returns to stockholders with company growth needs. This balancing act may cause these ratios to fluctuate from year to year and may provide an opportunity for investors to determine if the company is making the best use of its financial resources.