As dull or cumbersome as the topic sounds, financial ratios are indeed the “meat” of analyzing stocks. Sadly, most investors don’t exercise their due diligence when it comes to doing some relatively easy things to make sure that the company they’re investing in is a good place for their hard-earned investment dollars. A solid company doesn’t have to pass all these ratio tests with flying colors, but at a minimum, it should comfortably pass the ones regarding profitability and solvency.
Is the company making money? Is it making more or less than it did in the prior period? Are sales growing? Are profits growing? You can answer these questions by looking at the following ratios:
• Return on Equity
• Common Size Ratio (Income Statement)
• Return on Assets
Is the company keeping debts and other liabilities under control? Are the company’s assets growing? Is the company’s net equity (or net worth or stockholders’ equity) growing? You can answer these questions by looking at the following ratios:
• Working Capital
• Quick Ratio
While you examine ratios, keep these points in mind
- Not every company and/or industry is the same. A ratio that seems problematic in one industry may be just fine in another. Investigate.
-A single ratio isn’t enough on which to base your investment decision. Look at several ratios covering the major aspects of a company’s finances.
- Look at two or more years of a company’s numbers to judge whether the most recent ratio is better, worse, or unchanged from the previous year’s ratio. Ratios can give you early warning signs regarding the company’s prospects.
Liquidity means the ability to quickly turn assets into cash. Liquid assets are simply assets that are easier to convert to cash. Real estate, for example, is certainly an asset, but it’s not liquid because converting it to cash could take weeks, months, or even years. Current assets such as checking accounts, savings accounts, marketable securities, accounts receivable, and inventory are much easier to sell or convert to cash in a very short period of time. Paying bills or immediate debt takes liquidity. Liquidity ratios help you understand a company’s ability to pay its current liabilities. The most common liquidity ratios are the current ratio and the quick ratio, the numbers to calculate them are located on the balance sheet.
Operating ratios essentially measure the company efficiency. “How is the company managing its resources?” is a question commonly answered with operating ratios. If, for example, a company sells products, does it have too much inventory? If it does, that could impair the company’s operations.
Solvency just means that the company isn’t overwhelmed by its liabilities. Insolvency means “Oops! Too late.” You get the point. Solvency ratios have never been more important than they are now. Solvency ratios look at the relationship between what the company owns and what it owes.
Common Size Ratios
Common size ratios offer simple comparisons. You have common size ratios for both the balance sheet (where you compare total assets) and the income statement (where you compare total sales)-
- To get a common size ratio from a balance sheet, the total assets figure is assigned the percentage of 100 percent. Every other item on the balance sheet is represented as a percentage of total assets. For example, if Holee Guacamolee Corp. (HGC) has total assets of $10,000 and debt of $3,000, you know that total assets equal 100 percent, while debt equals 30 percent (debt divided by total assets or $3,000 ÷ $10,000, which equals 30 percent).
- To get a common size ratio from an income statement (or profit and loss statement), you compare total sales. For example, if a company has $50,000 in total sales and a net profit of $8,000, then you know that the profit equals 16 percent of total sales.