The 5 Categories of Financial Ratios
Financial ratios can be a great tool in your analysis toolbox as an investor. They can help you gauge the strength, profitability, efficiency, and quality of a business from a variety of different angles, as well as monitor changes in the firm's core operating metrics over time.
It can help you both offensively, looking for opportunities, and defensively, seeking to protect yourself whether you own the stock, invest in the bonds, or somehow expect to enter into a real estate investment with the business, such as a landlord doing a sale-leaseback transaction with a major drug store or restaurant chain. It's important that you memorize the most important of these financial ratios. It helps to classify them into five major categories mentally.
- Leverage: The financial ratios that give you an idea of the leverage inherent in the business, such as the debt-to-equity ratio or other ratios that allow you to see a company's capital structure, along with the potential benefits and risks of such a capital structure and how it compares to those of competitors in the same sector or industry, are what I call leverage financial ratios. It helps to put them in context with a complete understanding of the variables at play in a DuPont ROE analysis of a firm.
- Liquidity: Liquidity financial ratios show the solvency of a company based on its assets versus its liabilities; things like working capital per dollar of sales and the current ratio. In other words, it lets you know the resources available for a firm to use to pay its bills, keep the lights on, and pay the staff. Do not underestimate the importance of liquidity as a lack of it has caused even highly profitable businesses to go bankrupt.
- Operating: This category of financial ratios shows the efficiency of management and a company’s operations in utilizing its capital, especially through the cash conversion cycle in pursuit of profit. In the retail industry, this would include metrics such as inventory turnover and accounts receivable turnover. Companies that consistently have superior operating financial ratios often possess something known as franchise value.
- Profitability: A firm's profitability financial ratios are designed to give you an idea of how lucrative it is relative to some particular metric. A firm that has high gross profit margins from a sustainable business from a core product like bleach, laundry detergent, or chocolate, to provide an illustration, is going to be much harder to put out of business when the economy turns down than one that has razor-thin margins.
Likewise, a company with high returns on capital, even with smaller margins, is going to have a better chance of survival because it is so much more profitable relative to the shareholders’ contributed investment. Of particular importance is return on equity and return on assets.
- Solvency: The final major category of financial ratios new investors should know is meant to give you a reasonable idea, to the extent it can be predicted from the historical financial statements, the chances of a company being unable to cover its obligations when liabilities are subtracted from assets.
Even the most wonderful business can be in danger of wipe-out if it is undercapitalized and lacks the equity to absorb any challenges should the economy enter a recession or depression.
One More Thing
As useful as financial ratios are, they can't tell you everything. Imagine you were considering investing in a horse and buggy manufacturer when Henry Ford came out with the Model T. The historical income statement, balance sheet, and financial ratios wouldn't have told you what you needed to know as the business you were examining was on the brink of suffering a significant decline in income.
On the other side, imagine looking at the incredibly ugly financials of what was then called Apple Computer, now just Apple, prior to the return of Steve Jobs from exile when he transformed the business he founded, taking it on a run that ended up resulting it in having the world's largest market capitalization.