4 Financial Ratios For Investment Beginners
Invest Time on Picking up the Basics
Responsible investment is a key aspect of financial independence and preparation for retirement. There are two engines vital to achieve financial stability - wealth creation and wealth preservation. Most new investors tend to overlook wealth preservation, as accumulation of wealth is commonly prized as a primary and sole objective.
Investment is a prime vehicle to drive wealth preservation, encouraging asset growth in a sustainable manner. Investment of this nature can be made via a number of methods including fixed deposits (1 - 2% returns per annum), investment-linked policies (part of whole life insurance policy plans), corporate bonds, stocks and shares, and real estate portfolios.
As an example, a recent BlackRock Global Investor Pulse survey found that Singaporeans rely too heavily on cash in their investment portfolios and should diversify. The average investment portfolio for an investor in Singapore features 48 per cent cash holding, while equities (18 per cent), property (8 per cent), bonds (5 per cent), and other alternatives (3 per cent) make up the balance.
What You Need to Know Before Learning About the 4 Financial Ratios
Before learning about the four financial ratios, novice investors should familiarise themselves with the concepts of liquidity and barriers to entry.
The liquidity of stocks determine your ability to convert it to cash and the time this transaction would require. For example, if an investor purchased stocks today and required cash in a week’s time, it would be relatively easy to sell them on the stock market. However, purchasing private property and wanting to sell it in a similarly short timeframe would not be as easy, as investors would be subject to market conditions and other factors.
Barriers to entry when considering investment options are based on the initial outlay expected when making an investment. For example, a real estate investment requires a high 10-20 per cent downpayment, discouraging new investors from considering it as an option. On the contrary, stocks and bonds have much lower barriers to entry, making them much more attractive vehicles to invest in.
A third concept which is important to note is research. Novice investors tend to listen to expert advice from their friends or brokers, which may not always promise results. Instead, investors should perform their own research and come to informed decisions suited for their current situation and risk appetite, as every individual begins their investment journey on a different footing.
The financial ratios discussed in this article provide a good indicator of the overall health of companies you may consider for investment.
The 4 Financial Ratios
1. Revenue growth
The first value to research is company revenue growth. Research should identify if the revenue of the company has been growing at a decent rate annually over the last three to five years. A good marker is an average growth rating of 5 per cent annually over the past five years.
Investors should read company annual reports and industry or mainstream media publications to gain additional background on the company and industry before making an informed estimate of their revenue potential in the coming years.
2. Net profit margins
The next item to research is the net profit margin of the company. The net profit margin of a company is the percentage of revenue remaining after operating expenses, interest, taxes, and preferred stock dividends have been deducted from total revenue.
As a market guide, a net profit margin of 10% and above is considered healthy. Do note that net profit margins should be above 7% to warrant consideration, based on the individual industry.
3. Return on equity
The return on equity (ROE) or return on net worth calculates how many dollars of profit the company generates with each dollar of shareholders’ equity. Essentially, this ratio measures a corporation’s profitability by revealing how much profit a company generates with all the money shareholders have invested.
The higher this ratio, the better performance the company displays. As a guide, an ROE ratio above 15% is considered strong company performance.
The debt-to-equity ratio (D/E) indicates the relative proportion of shareholders’ equity and debt used to finance a company’s assets. This figure is obtained by dividing a company’s total liabilities by the stockholders’ equity. Essentially, this ratio indicates how much debt a company is using to finance its assets compared against the amount of value represented in shareholders’ equity.
The lower the D/E ratio, the less debt a company is saddled with. Investors should look for companies with a D/E ratio of 0.5:1 or lower.
There are several other factors important to consider before commencing a journey in investing, but the above listed ratios are what most investment gurus set benchmarks against when evaluating a company and its earning potential.
Industry-wide, these ratios are considered good indicators of a company’s track record and projected future performance levels. However, do bear in mind that seasoned investment veterans go through much more information than the above ratios before making decisions. Making investments is an individual decision, with many factors that should be considered carefully before commencement.
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