Equity Investing: ROE, P/E, EPS, Current Ratio, Debt/Equity - Essay Sample

Introduction

The main ratios for a potential equity investor are Return on Equity (ROE), Price-Earnings (P/E) ratio, and current ratio. Other metrics are Earnings per Share (EPS), and Debt-Equity Ratio. This selection of ratios is useful to equity investors because it provides details regarding a company’s financial situation and risk level, all of which affect equity investments.

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Earnings per Share

This ratio measures the income that investors can potentially earn from each ordinary share. Investors need to know EPS since they participate in the future loss and profits of a company through equity investments. EPS value is found by dividing net profit or income by the shares outstanding at the end of a financial year. For example, EPS for a company with 11 million outstanding shares, net income of $1 million and $250,000 as dividends would be $0.068. ($1M –250, 000)/11M).

Debt-Equity Ratio

It indicates the proportion of equity and debt in a business enterprise. This metric is vital to equity investors as it shows how debt financing in a corporation affects earnings available to them (Michael & Albert, 2014). One can determine this metric by dividing total outstanding debt by shareholders' equity book value. As an example, a firm with a debt of $3.1 million and $13.3 million shareholders’ equity will have a debt-equity ratio of 0.23. Since this metric is less than one, it indicates that a company relies on equity financing than loans.

Price-Earnings (P/E) Ratio

It is the measure of the current share price relative to its EPS. E/P is obtained by dividing the price of a unit ordinary share by EPS. For example, if a corporation had EPS $4.9 and a share price of $46.51 in a particular year, its P/E ratio would be 9.49.

Current Ratio

This financial metric is useful to equity investors as it shows an organization's ability to pay its short-term debts. It is determined by dividing total current assets by near-term liabilities. If, for instance, an entity had current assets $4million and current liabilities $3million, then its current ratio is 1.33. Since it is greater than one, it shows that this firm can pay short-term debts.

Return on Equity

This metric is used to determine a corporation’s ability to utilize shareholders’ money to make profits. It is determined by subtracting a firm’s preferred dividends by net income and the result divided by common equity. As an example, a company with common equity $8Million, $300,000 preferred dividends, and $1.3Million net income will have 12.5% ROE.

Corporate Bonds

The five main ratios to consider before investing in corporate bonds are debt-to-equity ratio, debt-to-capital ratio, operating profit margin, solvency ratio, and interest coverage ratio. In this regard, the five financial tools are the most important financial ratios since they help evaluate the company's solvency level, ability to pay interest, and meet debt obligations.

Solvency Ratio (SR)

This financial metric is used for determining the probability of a company defaulting its debt obligations by assessing the sufficiency of cashflows to pay long and short-term obligations. SR is determined by dividing net operating profit after tax by the company's total debt obligations. If, for example, a business entity has debt obligations $23,739 and net income $5,035, SR would be 21.21%. This figure suggests that a business can use its net operating income to service its long-term debts.

Operating Margin (OM)

This financial tool measures the amount of profit that a business enterprise can generate on every dollar of sales after meeting all expenses related to variable costs. OM is determined by dividing the value of operating earnings by revenue. If, for instance, a firm has operating earnings of $1 million and revenue $1.5M, OM would be 66.67%.

Interest Coverage Ratio (ICR)

This debt ratio is used to assess how easily a corporation can pay interest on the outstanding obligations. ICR is calculated by dividing EBIT by the interest expense. If, for instance, a business has EBIT $2Million and interest expense $5000, its ECR would be $40.

Debt-to-Capital Ratio (DCR)

Bond investors would use this ratio to determine an organization’s financial leverage. It is calculated by dividing a corporation's total interest-bearing debt by its capital: the higher DCR, the riskier the company. So, a firm with DCR 20% would be attractive than that with 30%.

Debt to Equity Ratio (DER)

This ratio would allow the bond investors to assess the proportion of an organizations' debt from the issuance of bonds to its equity. Depending on the industry, a bond investor can commit his resources if the company's DER is between 1 and 1.5.

Potential Bank Investment

The main ratios that this person should consider before investing in short-term corporate loans are Return on Assets (ROA), loan-to-asset ratio, net interest margin, liquidity coverage ratio, and current ratio. The reason is that these metrics focus on critical aspects of banking institutions like interest (bank’s revenue) and cash, which is treated as assets. Also, these ratios focus on liquidity, which is an essential consideration when investing in short-term loans.

Liquidity Coverage Ratio (LCR)

LCR indicates the capacity of a baking institution to pay its near-term obligations without using money from outside the organization. It is computed by dividing the value of liquid assets by the amount of cash flow. For example, if a bank has net cashflows $35million and $55million liquid assets, its LCR would be 157%, and it shows that it can pay short term loans.

Net Interest Margin (NIM)

NIM helps investors of short term loans find the difference between interest expense and interest income. A bank with $10,000 interest expense, $40,000 interest income and $200,000 assets will have NIM of 15% (40,000 – 10,000)/200,000.

Return on Assets (ROA)

ROA shows the bank's returns per dollar (cash as assets). Since banking institutions are highly leveraged, investors ought to commit their resources on this investment if ROA is positive. If, for example, the bank's total assets are $5 million and its income after tax is $2million, ROA would be 40%.

Loan-to-Asset Ratio (LAR)

This ratio shows the proportion of a bank's loans to assets. Banks with higher LAR derive their income from investments and loans, while those with low LAR generate their earnings from non-interest sources. As an example, between bank ABC with 5% LAR and bank XYZ with LAR 20%, an investor should invest in ABC as it can perform well even with low-interest rates.

Current Ratio

It shows how equipped a banking institution is to pay short-term loans, among other near term obligations (Michael & Albert, 2014). For banks, a current ratio value less than one is a concern as the organization's liquidity status would not allow it to pay near-term loans.

Investment in Stock

Potential investors should determine the following ratios before purchasing stock: Price-Earnings (P/E) ratio, net margins, dividend payout ratio, ROE, and earnings per share. The justification they measure earnings that shareholders can get from investing in the stock. So, they are the right metrics since they measure key aspects underlying the goal of stockholders.

Dividend Payout Ratio (DPR)

DPR measures the proportion of dividend payments to the company's income: the higher DPR, the better dividends. As an example, a company that paid $20,000 as dividends and generated income $60,000 would have DPR of 33.33% (20,000/60,000) X 100).

Net Margins

It measures how an organization generates profits out of its sales. It is computed by dividing net earnings by totals sales—the higher this metric, the better to investors. As an example, a company with a net margin of 30% would be a better investment choice than a firm with 20%.

Returns on Equity

It is useful to stock investors as it measures how a company uses its resources to generate earnings. ROE formula involves dividing a firm's net profit by the average stock equity. The higher ROE, the better a firm to investors. ROE 24%, for instance, is favorable than ROE 13%.

Earnings per Share (EPS)

EPS allows stock investors to determine the money that a firm can make from each share. Higher EPS means investors get more earnings and vice versa. If a firm has outstanding shares of $1 million and profit $2million, for instance, its EPS is $2. (2M/1M).

Price-Earnings (P/E) Ratio

It enhances potential stock investors to determine the current share price relative to EPS. A high P/E implies that stockholders expect more returns. This aspect is determined by dividing the market value per share by EPS. If, for example, the market value of a corporation's share is $30, and EPS is $13, the P/E ratio would be $2.3 (30/13).

Review of the Article

The article by Kaminski et al. (2004) studied if ratios can help detect fraud in financial statements. The authors said that this topic should be studied because fraudulent financial reporting in the present-day business environment has significant social and economic effects. In this regard, the primary research question addressed is, "do the financial ratios of fraudulent companies differ from those of non-fraudulent companies?” (Kaminski et al., 2004, p. 15).

The authors obtained a sample of companies that have ever engaged in the deliberate manipulation of accounting records from the Securities and Exchange Commission (SEC). Such information is outlined in the SEC's Accounting and Auditing Enforcement Releases (AAERs). However, researchers used AAER’s information published from 1982 to 1999. Corporations reported in AAER for having manipulated their books of accounts were categorized as potential sample fraud companies.

In this study, researchers used the original financial records instead of the restated ones as a strategy to minimize hindsight bias. The authors collected data of companies that engaged in financial statement fraud from annual report files as well as SEC 10K. COMPUSTAT was then used to match businesses that engaged in fraud with those that did not perpetuate the unlawful act in three main dimensions, namely, industry, firm size, and reporting period. The authors compared non-fraud corporations with those that manipulated their financial reports if their asset base was within - /+ 30% of the latter (Kaminski et al., 2004). Ratios that empirical research had demonstrated to be useful were used in the analysis followed by multivariate analysis.

An analysis of a multitude of financial ratios of the two sets of corporations showed that there are no many statistical differences regarding financial ratios of non-fraud and fraud companies. The research thus concluded that ratio analysis has limited ability to detect fraud in reporting financial information since there is no significant difference between ratios of non-fraudulent and fraudulent corporations. This idea is of great importance to auditors as well as standard setters in the application of ratios to determine instances of dishonest reporting.

References

Kaminski, K. A., Wetzel, T., & Guan, L. (2004). Can financial ratios detect fraudulent financial reporting? Managerial Auditing Journal, 19(1), 15-28. https://doi.org/10.1108/02686900410509802

Michael, R., & Albert, J., P. (2014). Ratios overview: Financial Ratios for Executives, 1-5. https://doi.org/10.1007/978-1-4842-0731-4_1