4 financial ratios to understand before buying shares

It’s not hard to identify high-quality businesses when you consider some simple financial indicators.

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Share market investors come from all walks of life and you don’t necessarily need to have a degree in accounting, economics or financial mathematics to get involved and be successful.

Although a degree in accounting would obviously help in analysing financial statements more thoroughly, I think a basic understanding of a few key metrics is all you need to get started.

While opinions may differ as to the importance and application of different financial metrics, I believe those highlighted below are some of the most important and can provide investors with a pretty good starting point for analysing a company:

1. Return on equity (ROE) – In simple terms, this measures how many dollars of profit a company generates on the money put up by shareholders.

In the short term a company’s ROE may not be very important, but over the long term, a company’s ROE can be an important driver of shareholder returns.

For example, over the past six years REA Group Limited (ASX: REA) has consistently delivered a ROE of around 35%. A company like Fairfax Media Limited (ASX: FXJ), on the other hand, has struggled to generate a ROE of more than 10% over the past decade and this has delivered poor results for its shareholders.

Investors should note that the ROE can be influenced by a company’s debt profile and, therefore, should not be viewed in isolation.

2. Net debt to equity ratio – This is an important measure of risk for both investors and the company itself.

While there is no universally accepted level of gearing a company should or should not have, it is up to investors to determine whether or not they are comfortable owning a company with excessive levels of debt.

A recent example of a company that has struggled under the weight of too much debt is Slater & Gordon Limited (ASX: SGH). After taking a massive impairment charge, the law firm now has a net debt to equity ratio approaching 200%.

3. Earnings before interest and tax (EBIT) margin – This essentially measures how much profit is created from business operations, independently of the way the company is financed or taxed.

Unlike gross margins, EBIT margin takes into account all of the costs associated with running a business including administrative and marketing expenses.

Ideally, investors should look for companies that have the ability to grow or, at the very least, maintain their EBIT margins even when faced with higher levels of competition. This could indicate a company has an economic moat.

REA Group, for example, has steadily grown its EBIT margin to around 52%, even with the rise of new competitors. Compare this to a company like Metcash Limited (ASX: MTS), which has seen its EBIT margin fall to around 2% recently thanks to an increase in competition in the supermarket sector.

4. Dividend payout ratio – I think this is an important ratio because it offers investors an insight into where a company might be currently operating in the business life-cycle.

A fast growing company is unlikely to pay out a significant portion of its profits as dividends because it needs to re-invest this money for future growth.

For example, TPG Telecom Ltd (ASX: TPM) retains around 60% of its profits to fund its pipeline of growth opportunities. Telstra Corporation Ltd (ASX: TLS), on the other hand, has limited growth opportunities and this sees the company pay most of its profits as dividends to shareholders.

Foolish takeaway

There are many more financial measures investors could consider before making an investment decision, but those highlighted above should provide investors with a good foundation for further research.

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Motley Fool contributor Christopher Georges has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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