A financial ratio is simply one number from a company's financial results divided by another. Simple, yet incredibly powerful. Ratios are like having a flashlight in a cave, so you shouldn't stumble around in the dark with your investments anymore.
Ratios allow you to compare penny stocks to massive blue-chip corporations or contrast a business against any of its competitors. They also allow you to track the health of the underlying company and watch to see if they are getting stronger or fading.
Knowing a single value is meaningless. For example, are sales of $1.3 million good? That depends. If a billion-dollar corporation was only bringing in seven figures, that would be very bad, while it might be positive for the newest up-and-coming penny stock.
However, if you had the share-price-to-sales ratio (price-to-sales, or P/S), you can clearly see if the value of the stock is compelling, or much more expensive than its peers. In fact, using a few simple financial ratios that work well with low-priced shares will provide a crystal clear picture of the operational results and future potential of the underlying business.
- Financial ratios are important tools for investors to use when evaluating the earnings potential of a business.
- Ratios that don't rely on earnings numbers can be helpful for evaluating penny stocks, which are shares in smaller, newer businesses.
- In particular, penny stock investors should look at the price-to-sales ratio, current ratio, quick ratio, and debt ratio, along with operating cash flow and inventory turnover.
Finding the Right Ratios
When it comes to penny stocks, only certain ratios are helpful, but those that work will completely change your outlook. Since smaller and newer businesses typically don't have earnings, then gross and net profit margins cannot be calculated, for example.
However, valuation metrics such as sales per share can be quickly derived from the latest financial results or found through an online financial portal. Look for stronger financial ratio values compared to the competition, as well as improvements in the numbers from one quarter to the next.
There are six ratios, in particular, that should help you to evaluate penny stocks. Let's look at each in turn.
1. Price-to-Sales (P/S)
By dividing the current share price of the penny stock by the company's annual sales, you will see if the investment is over or undervalued.
For example, if the shares trade at $2.50, and the company brought in sales of $1 per share for the year, that is a P/S of 2.5. Lower values are better than higher ones, and anything close to 2.0 or less is compelling.
2. Current Ratio
This one is of monumental importance with penny stock companies. By dividing current assets by current liabilities, you will see how well the business can cover its short-term debts with short-term assets.
For example, picture a company with $2 million in current assets, and $1 million in current liabilities. Their current ratio would be 2.0.
Avoid any penny stocks with a current ratio less than or near 1.0. Ideally, you'll find investments that boast this value at 2.0 or more - the higher, the better.
3. Quick Ratio
While the current ratio takes all assets into account, the quick ratio only considers assets that can quickly and easily be used. This means it doesn't include items like inventories but rather focuses on cash, marketable securities, stock market investments, and accounts receivable.
By dividing the more liquid assets by the current liabilities, you will get an idea of how many times over the business can more easily cover what it owes in the short term.
If a penny stock has $2 million in cash, $500,000 in accounts receivable, and $500,000 in marketable securities (stocks), divided by $4 million in current liabilities, that would generate a quick ratio of 0.75.
$3 million in quick assets, over $4 million in current debts = 0.75. In this example, the business would not have enough to cover what it owes.
Always look for a quick ratio of at very least 1.0, but ideally 2.0 or more. Higher numbers are better.
4. Operating Cash Flow
This considers cash flow from operations, then divides it by current liabilities. This ratio shows how well the penny stock business can cover what it owes in the short term (the next 12 months) using its cash flow.
Higher numbers are better than lower, but even values slightly below 1.0 are acceptable.
5. Inventory Turnover
This shows how effective the business is in producing and selling products. A company that produces and sells its inventory five times a year is twice as efficient as one which produces and sells its inventory only 2.5 times.
The inventory turnover ratio will vary significantly, depending on the industry in which the business is involved. An aircraft manufacturer will have a much lower value than an ice cream shop. However, using the ratio in comparison to the competition, or in contrast, the previous periods for the company itself, will provide excellent insights.
6. Debt Ratio
This is a simple one, but it is an important one. Just divide total liabilities by total assets. If a company has four times more in assets value than liabilities, the debt ratio will be 0.25.
In this example, the business is in solid financial shape. Be cautious when you see debt ratios anywhere near 1.0. If you are selective, look for values below 0.5.