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Have £5k to invest? Make sure you look at these financial ratios!

For some, investing in stocks is very simple. They look at what the company does, and if they think that it is a fundamentally sound business, they look to buy the stock.

For others, before any investment they pour over historical data, technical analysis, earnings reports, and more. Nothing is left out in the process of deciding whether the company is viable or not.

I do not discredit either approach, but would definitely recommend taking a look at (and understanding) the below financial metrics before investing, as I think they provide a valuable insight into a business.

Dividend yield ratio

This is a number which is particularly important for investors looking to buy a share for income. The dividend yield of a stock is its annual dividend paid out per share, divided by the share price. So if a company is paying 10p per share as a dividend and the company trades at 100p, the dividend yield is 10%. 

If you are looking to invest in order to receive high dividend payouts relative to the share price, look for firms in the FTSE 100 with a high yield. Evraz currently has the highest dividend yield in the FTSE 100 at almost 16%. 

While you do need to be careful about exceptionally high dividend yields, companies such as HSBC, BT, and ITV all have yields of over 5%.

Price-to-earnings ratio

This follows on nicely from the dividend yield ratio. Instead of looking at the dividend paid per share, we look at the earnings per share, and use the share price to divide into it to give us a figure. For example, if a company is trading at 100p and has earnings per share of 5p, it would have a P/E ratio of 20.

You need to be more careful when deciding whether or not to invest on the basis of the P/E ratio. The general theory is that a firm with a high P/E ratio is overvalued, although the flip side of this is that the company is expecting higher earnings in the future (and could thus justify a high ratio).

When I looked at Greggs recently, it had a high P/E ratio of 31 (almost double the FTSE All Share average). Yet the growth prospects at the firm look solid, so it still constitutes a buy in my opinion.

Net profit margin ratio

Arguably the most important figure that any business has to report is the net profit margin. Quite simply, what proportion of funds is left over from revenue once all costs of sales, operating costs (including salaries, rent, etc.) and taxes have been deducted. The higher, the better.

Do note though that you need to compare the profit margin on a relative basis to firms in the same industry. For example, supermarkets like Tesco and Sainsburys have very low profit margins, often around 2%. So while a firm may have a low profit margin relative to the FTSE 100 in general, it may be high within its industry.

Overall, the ratios mentioned above can offer you a really good quick insight into whether a company is performing well, and indeed can give you an indication as to how the market rates them (shown via the share price element). Make sure you look at them before making a call on whether to invest.

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Jonathan Smith does not own shares in any firms mentioned. The Motley Fool UK has recommended HSBC Holdings, ITV, and Tesco. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.