Many standard ratios are used to understand the financial condition of an organization. The P/E ratio is one of those standard ratios. This ratio allows the shareholders, creditors, and financial analysts to understand how the company is doing. This ratio tells about the strengths and weakness as well. Investment firms, bank loan officers, and business owners use this ratio to learn about a company’s financial health and make important business decisions.
The P/E ratio is not complicated to calculate. You have to do some simple calculations and comparisons from the data available in the balance sheet and income statement. This should be easy; all of us have studied ratios in our school days that reveal the relationship between two numbers. For example, suppose you want to buy shares of a company and the company is selling at $20 per share and the company’s earnings per share is $2, then the ratio of price to earnings is 20 to 1. It is said its P/E ratio is 20.
You can use financial ratio analysis in two different ways. You can use it to learn the present performance of a company in comparison to past performances; this allows you to learn the problems that have been or that still need to be fixed. Second, you can use financial ratio analysis to study the performance of one company in comparison to another company or industry.
When you are doing calculations, you must keep in mind that financial ratio analysis is intended to show broad trends, so limited conclusions can be drawn from a single ratio. It is better to study a constellation of ratios and try to determine a common thread or general theme in the data as a whole.