To fully understand the financial position of a company it is very important for an investor to know the liquidity position, financial leverage, and valuation of the company. Below mentioned ratios are very helpful in doing the fundamental analysis of the company.
The current ratio measures the company’s ability to pay its short-term obligation by comparing its current assets and current liabilities. It is computed as follows:
Current Ratio = Current Assets / Current Liabilities
Current assets are those assets which can be converted into cash with a span of 1-year like cash, accounts receivable, inventory, etc. Current liabilities are those liabilities which are having a maturity date of less than one year like accrued expenses, taxes payable, notes payable, short-term creditors, etc.
If a company is having a current ratio less than one (<1), it means that the company is not having enough cash to pay off its short-term liabilities. On the other hand, if the current ratio is more than one (>1), it means that the company has decent liquidity position to pay off its short-term obligations. A current ratio is a useful tool in determining the liquidity of the company; however, one should not solely depend on this ratio to assess the solvency of the company.
Debt to Equity Ratio
A capital structure of the company consists of both equity and debt. Debt to Equity Ratio is generally used in accessing a company’s financial leverage by calculating the weight of the company’s total debt against the total shareholder’s equity. Debt to Equity Ratio is calculated by dividing the total debt of the company by its total shareholder’s equity. It is computed as follows:
Debt to Equity Ratio = Total Debt/ Total Shareholders’ Equity
Debt to Equity Ratio is an important ratio for accessing the creditworthiness of the company. A higher Debt to Equity ratio of the company generally indicates the company has relatively higher debt as compared to its equity which means that the company is riskier. Similarly, if the Debt to Equity Ratio is low, it means that the company is less risky. A very low debt to equity ratio indicates the company is not fully utilizing its ability to borrowed debt.
Price/Earnings to Growth ratio (PEG ratio)
Price/Earnings to growth ratio (PEG ratio) of a company is calculated by dividing its price/earnings ratio (P/E ratio) by its percentage growth rate. Earnings per share, Current Price per Share and expected growth rate are the three main components of this ratio. It is computed as follows:
PEG Ratio = P/E ratio/ Expected growth rate
The price/earnings ratio which is an important component of Price/Earnings to Growth ratio is calculated by dividing the company’s stock price to the company’s earnings per share. P/E ratio is generally used to find out whether the stock is overvalued on undervalued. However, PEG ratio is considered more appropriate to find the valuation of the company as it takes into the account of the company’s expected growth rate to get the complete picture.
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