Six Basic Financial Ratios on HOW TO VALUE A COMPANY

1. Working Capital Ratio

2. Quick Ratio

3. Earnings per Share (EPS)

4. Price-Earnings (P/E) Ratio

5. Debt-Equity Ratio

6. Return on Equity (ROE)

These include price-earnings (P/E), earnings per share, debt-to-equity and return on equity (ROE).

1. Working Capital Ratio

Working capital represents a company's ability to pay its current liabilities with its current assets. Working capital is an important measure of financial health since creditors can measure a company's ability to pay off its debts within a year.

So, if ICM Corp. has current assets of K8million, and current liabilities of K4million, that's a 2:1 ratio—pretty sound. But if two similar companies each had 2:1 ratios, but one had more cash among its current assets, that firm would be better able to pay off its debts quicker than the other.

2. Quick Ratio

Also called the acid test, this ratio subtracts inventories from current assets, before dividing that figure into liabilities. The idea is to show how well current liabilities are covered by cash and by items with a ready cash value. Inventory, on the other hand, takes time to sell and convert into liquid assets.

If ICM has K8million in current assets minus $2 million in inventories over K4million in current liabilities, that's a 1.5:1 ratio. Companies like to have at least a 1:1 ratio here, but firms with less than that may be okay because it means they turn their inventories over quickly.

3. Earnings per Share (EPS)

When buying a stock, you participate in the future earnings (or risk of loss) of the company. Earnings per share (EPS) measures net income earned on each share of a company's common stock. The company's analysts divide its net income by the weighted average number of common shares outstanding during the year.

If a company has zero or negative earnings (i.e. a loss) then earnings per share will also be zero or negative.

4. Price-Earnings (P/E) Ratio

Called P/E for short, this ratio reflects investors' assessments of those future earnings. You determine the share price of the company's stock and divide it by EPS to obtain the P/E ratio.

If, for example, a company closed trading at K46.51 a share and EPS for the past 12 months averaged K4.90, then the P/E ratio would be 9.49. Investors would have to spend K9.49 for every generated dollar of annual earnings.

Note that if a company has zero or negative earnings, the P/E ratio will no longer make sense, and will often appear as N/A for not applicable.

Even so, investors have been willing to pay more than 20 times the EPS for certain stocks if hunch that future growth in earnings will give them an adequate return on their investment.

5. Debt-Equity Ratio

What if your prospective investment target is borrowing too much? This can reduce the safety margins behind what it owes, jack up its fixed charges, reduce earnings available for dividends for folks like you and even cause a financial crisis.

The debt-to-equity (D/E) is calculated by adding outstanding long and short-term debt, and dividing it by the book value of shareholders' equity. Let's say ICM has about K3.1million worth of loans and had shareholders' equity of K13.3million. That works out to a modest ratio of 0.23, which is acceptable under most circumstances. However, like all other ratios, the metric has to be analyzed in terms of industry norms and company-specific requirements.

The Bottom Line

Applying formulae to the investment game may take some of the romance out of the process of getting rich slowly. But the above ratios could help you pick the best stocks for your portfolio, build your wealth and even have fun doing it. There are dozens of financial ratios that are used in fundamental analysis, here we only briefly highlighted six of the most common and basic ones. Remember that a company cannot be properly evaluated or analyzed using just one ratio in isolation - always combine ratios and metrics to get a complete picture of a company's prospects