Lesson 6b: The Language of Business part 2

Value Investing 101: Introductory

Financial Terms and Ratios Every Investor Should Know

Now that we have covered financial statements in detail, it’s time to explore how we interpret and analyze the numbers from these reports.

Why Are Ratios Important?

Financial ratios help investors compare companies, identify trends, and detect potential issues. They standardize figures, making it possible to compare a large company with a small one and with industry averages.

We divide financial ratios into five main categories:

• Profitability Ratios

• Liquidity Ratios

• Leverage Ratios (Solvency)

• Efficiency Ratios

• Valuation Ratios

Let’s go through them one by one in detail.

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1. Profitability Ratios: How Profitable Is the Company?

These ratios measure how effectively a company generates profit from its revenue and assets.

1.1 Gross Profit Margin

\(\text{Gross Profit Margin} = \left( \frac{\text{Gross Profit}}{\text{Revenue}} \right) \times 100\%Gross Profit Margin=(RevenueGross Profit​)×100% Gross Profit=Revenue−Cost of Goods Sold (COGS)\text{Gross Profit} = \text{Revenue} - \text{\)

This ratio shows what percentage of revenue remains after direct production costs.

• A higher gross profit margin indicates strong pricing power and cost efficiency.

👉 Example:
A company has revenue of €1,000,000 and production costs of €600,000.

\(\text{Gross Profit} = 1,000,000 - 600,000 = 400,000\)

\(\text{Gross Profit Margin} = \left( \frac{400,000}{1,000,000} \right) \times 100\% = 40\%\)

1.2 Operating Profit Margin (EBIT Margin)

\(\text{Operating Profit Margin} = \left( \frac{\text{Operating Profit (EBIT)}}{\text{Revenue}} \right) \times 100\%\)

This ratio measures what percentage of revenue remains after all operating costs.

• A higher operating margin signals strong efficiency.

1.3 Net Profit Margin

\(\text{Net Profit Margin} = \left( \frac{\text{Net Profit}}{\text{Revenue}} \right) \times 100\%\)

This ratio shows how much of the revenue ultimately turns into profit for shareholders.

• A low net profit margin may indicate high taxes, high interest expenses, or inefficiencies.

1.4 Return on Assets (ROA)

\(\text{ROA} = \left( \frac{\text{Net Profit}}{\text{Total Assets}} \right) \times 100\%\)

Measures how much profit a company generates per euro of assets.

• A higher ROA indicates more efficient use of company resources.

1.5 Return on Equity (ROE)

\(\text{ROE} = \left( \frac{\text{Net Profit}}{\text{Equity}} \right) \times 100\%\)

This is the most important profitability ratio for shareholders.

• It shows how much profit is generated per euro of equity.

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2. Liquidity Ratios: Can the Company Meet Its Short-Term Obligations?

Liquidity ratios measure how well a company can pay off its short-term debts.

2.1 Current Ratio

\(\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}\)

• A value greater than 1 means the company has enough short-term assets to cover its debts.

2.2 Quick Ratio (Acid Test Ratio)

\(\text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}\)

• A stricter measure, since inventory is often difficult to convert quickly into cash.

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3. Leverage Ratios: How Much Debt Does the Company Have?

Leverage ratios assess long-term financial stability.

3.1 Debt-to-Equity Ratio (D/E)

\(\text{D/E} = \frac{\text{Total Debt}}{\text{Equity}}\)

• A high ratio (>2) means a high debt burden and greater risk.

• A low ratio (<1) indicates lower reliance on debt.

3.2 Interest Coverage Ratio

\(\text{Interest Coverage} = \frac{\text{EBIT}}{\text{Interest Expenses}}\)

• Measures how many times a company can cover its interest payments with operating profit.

• Below 2 can be risky, while above 5 is considered safe.

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4. Efficiency Ratios: How Efficiently Does the Company Manage Its Resources?

These ratios measure how well a company converts assets into sales and profits.

4.1 Inventory Turnover​

\(\text{Inventory Turnover} = \frac{\text{Cost of Goods Sold (COGS)}}{\text{Average Inventory}}\)

• High value = fast sales, minimal unsold inventory.

• Low value = risk of unsold stock.

4.2 Accounts Receivable Turnover

\(\text{Accounts Receivable Turnover} = \frac{\text{Revenue}}{\text{Average Accounts Receivable}}\)

• Measures how quickly customers pay their invoices.

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5. Valuation Ratios: How Is the Stock Priced?

These ratios help investors determine if a stock is overvalued or undervalued.

5.1 Price-to-Earnings Ratio (P/E)

\(\text{P/E} = \frac{\text{Stock Price}}{\text{Earnings Per Share (EPS)}}\)

• High P/E (>25) may indicate an overvalued stock, but also high growth expectations.

• Low P/E (<10) may suggest an undervalued stock, but could also signal problems.

5.2 Price-to-Book Ratio (P/B)

\(\text{P/B} = \frac{\text{Stock Price}}{\text{Book Value Per Share}}\)

• P/B < 1 can indicate an undervalued stock.

5.3 Dividend Yield

\(\text{Dividend Yield} = \left( \frac{\text{Annual Dividend Per Share}}{\text{Stock Price}} \right) \times 100\%\)

• Shows what percentage of your investment is returned annually as dividends.

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Conclusion

These ratios form the foundation of financial analysis. A smart investor examines multiple ratios simultaneously and compares companies within the same industry.

The start