Financial ratios are one of the fundamental aspects of analysis for many investors. These ratios are the investing equivalent of a thermometer -- while you won't always know why there is a fever, you will certainly see a change in temperature. There are three primary ratios that use stockholders' equity in their calculation, and each reveals a different element of business health.
Stockholders' Equity Ratio
The stockholders' equity ratio compares the stockholders' equity to total assets, and essentially shows how much a company's liabilities are eating into its net worth. This is also a good barometer for liquidity, or the ease with which a company can meet its financial obligations in regards to debt and expenses. In this case, a high ratio is good -- it indicates a smaller value of ongoing fixed expenses, or what many like to refer to as a "low overhead."
Return on Equity Ratio
The return on equity ratio measures a company's net income against total stockholders' equity. This is a way to monitor changes in income against the overall book value of the company, or how much of a company's net worth is tied up in its fixed assets and liabilities, and how much comes from business activities. In general, a higher ratio is better as this usually indicates lower debt, limited expenses and established assets -- signs that a company is making the most of what it has. This can be deceiving, however. Assets may be written off the books due to depreciation and the ratio may be skewed if business growth relies on non-quantifiable input -- innovation, sales and talent -- as is often the case in service industries. Many investors use the DuPont ROE -- a calculation that factors in asset turnover -- to further examine this information.
The debt-to-equity ratio looks at where a company gets its financing. The simplest form of the ratio consists of total outstanding debt to total stockholders equity, but it may also be helpful to look at long-term and short-term debt separately. This ratio shows the portion of company value that is funded by debt rather than by income, and it's generally better if the ratio is small. Of course, there's good debt and bad debt, and a rising DTE ratio may also indicate a drop in income, so any adverse change should incite further investigation rather than immediate action.
Financial ratios should never be taken out of context. After all, you wouldn't know 102 degrees was a fever if you didn't also know that normal was 98.6. Ratios are most helpful when they are compared to themselves over time, and to those of other very similar companies. A ratio isn't a clear sign to buy or sell, but rather an indication to look further into the health of a company.
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