October 11 2023

Understanding the Purpose of Financial Ratios in Trading

In-depth evaluations and computations in finance and economics offer valuable perspectives on financial conditions and the efficacy of existing metrics. But how exactly? The article will examine a few of the most broadly used and important financial ratios to measure your financial success.

What Is A Financial Ratio?

Financial ratios are crucial calculations used by traders and investors to evaluate the potential success of their ventures and drive decision-making. They provide valuable insights into the potential of current tactics and strategies.

These ratios provide rapid financial projections without the need for complex computations, making it simpler to determine whether an investment is profitable and what the expected returns will be. These numbers have important financial implications and are produced from numerous calculations, which are commonly accomplished using computer software or a basic calculator.

These indicators are crucial in various financial procedures like balance sheets, profit and loss statements, cash flow analysis, and feasibility analysis. They can reveal underestimated problems or potential issues not found in typical statements or projections, making understanding these ratios essential in finance.

Key Financial Ratios

Financial ratios are constantly advancing due to the ever-evolving business landscape. Nevertheless, some core ratios have remained relevant and stand the test of time, including the following:

ROE

The return on equity ratio is crucial, demonstrating investments’ success and asset management. Newly established companies often rely on angel investors, accelerators, and funds to launch operations and acquire necessary materials.

After a business is launched and operational, investors assess the ROE ratio to gauge its fiscal management and equity growth. Entrepreneurs calculate their ROE using the following formula:

ROE = Net Income / Shareholder equity

A high ROE demonstrates efficient investment and signals that the company performs well.

WCR

The working Capital Ratio is calculated as the value of the current assets divided by current liabilities.

Corporations aim to maintain profitability by balancing their assets and liabilities, with smaller assets over liabilities, to prevent expenses from outweighing revenues.

Acquiring liabilities like input materials, vendors, credit lines, and loans is essential for commercial activities. Monitoring the assets-to-liabilities ratio to ensure current assets add value to liabilities is crucial. The WCR measures a company’s performance compared to its assets, indicating how assets perform compared to liabilities.

A WCR ratio of less than 1 indicates inefficient monetary policy and liquidity issues, while a ratio between 1.5 and 2 indicates a solid financial position. If the WCR value exceeds 2, it signifies ineffective asset management.

EPS

Earning per share is a crucial ratio in stock exchange transactions, used by companies for public offerings planning and by investors for investment allocation.

The EPS ratio measures a company’s profitability and the expected earnings from owning its shares. Publicly traded corporations aim to boost their EPS ratio to attract investors, as higher EPS results in increased shareholder earnings.

There are two ways to calculate the EPS ratio:

  • EPS = (company’s net income – dividends to preferred shareholders) / average outstanding shares.
  • EPS = company’s net income / average outstanding shares.

Bottom Line

Financial ratios are critical for understanding a company’s financial position and tracking investments. They provide in-depth insights and guide a company’s monetary strategy. They are commonly used in capital statements and analyses, making understanding their workings crucial to identifying underlying financial gaps or opportunities.


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Author

Kyrie Mattos


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