5 Types of Financial Ratios for Analyzing Stocks
Financial ratios help you interpret the raw data of a company's finances to get a better picture of its performance. This will enable you to make prudent investment decisions, whether you're looking at blue chips or penny stocks. There are five basic categories of financial ratios for stock market analysis; the information you can glean from them will put you at an advantage compared to investors who don't do their due diligence.
What's a Ratio?
Simply put, a financial ratio means taking one number from a company's financial statements and dividing it by another. The result allows you to measure the relationship between different numbers.
For example, knowing that an investment's share price is $2.13 doesn't tell you much. But knowing the company's price-to-earnings ratio (P/E) is 8.5 provides you with more context: It tells you that its price ($2.13), when divided by its earnings per share (or EPS, in this case, $0.25), equals 8.5. You can then compare that P/E of 8.5 to the P/E of large corporations, direct competitors, or even to previous years of the same company to better gauge the attractiveness of the stock price as compared to its earnings.
You can find many of these ratios calculated for you and displayed on financial websites.
5 Types of Ratios
Different financial ratios give a picture of different aspects of a company's financial health, from how well it uses its assets to how well it can cover its debt. One ratio by itself may not give the full picture unless viewed as part of a whole.
Because they measure data that changes over time, ratios are by nature time-sensitive, so you should account for that when evaluating them. You can use this to your advantage and compare ratios from one time period to another to get an idea of a company's growth or changes over time.
Liquidity ratios demonstrate a company's ability to pay its debts and other liabilities. If it does not have enough short-term assets to cover short-term obligations, or it does not generate enough cash flow to cover costs, it may face financial problems.
Liquidity ratios are extra important with penny stocks specifically since the smaller and newer companies often have tremendous difficulties paying all of their bills before their businesses become stable and established.
Some liquidity ratios include:
- Current ratio
- Quick ratio
- Cash ratio
- Operating cash flow margin.
The current ratio, for example, is current assets divided by current liabilities, and it gives you an idea of how well the company can meet its obligations in the next 12 months.
The cash ratio will tell you the amount of cash a company has compared to its total assets.
The quick ratio will compare a company's cash, marketable securities, and receivables against its liabilities, giving you a better picture of how well it can make payments on its current obligations.
Activity ratios demonstrate a company's efficiency in operations. In other words, you can see how well the company uses its resources, such as assets available, to generate sales.
A few examples of activity ratios investors should apply in their research include:
- Inventory turnover
- Receivables turnover
- Payables turnover
- Working capital turnover
- Fixed asset turnover
- Total asset turnover
Inventory turnover is expressed as the cost of goods sold for the year divided by average inventory. This ratio can indicate how efficient the company is at managing its inventory as it relates to its sales.
Receivables turnover, as another example, indicates how quickly net sales are turned into cash; it's expressed as net sales divided by average accounts receivable.
Leverage, or solvency, ratios demonstrate a company's ability to pay its long-term debt. These ratios examine a company's dependence on debt for its operations and the likelihood it can repay its obligations.
Leverage ratios are also referred to as:
- Debt ratios
- Debt-to-equity ratios
- Interest-coverage ratios
The debt ratio compares a business's debt to its assets as a whole. A debt-to-equity ratio looks at a company's overall debt as compared to its investor-supplied capital; with this ratio, a lower figure is generally safer (although too low can indicate an excessively cautious, risk-averse company).
Interest-coverage ratios show how well a company can handle the interest payments on its debts.
Performance ratios tell investors about a company's profit, which explains why they are frequently referred to as profitability ratios.
Performance ratios tell a clear picture of a company's profitability at various stages of its operations. Examples include:
- Gross profit margin
- Operating profit margin
- Net profit margin
- Return on assets
- Return on equity
For example, gross profit margin will show the gross sales compared to profits; this number is found by subtracting the cost of goods sold from the total revenue and then dividing by total revenue.
Another ratio, operating profit margin, shows a company's operating profits before taxes and interest payments, and is found by dividing the operating profit by total revenue.
When looking at penny stock companies, it may be difficult or impossible to find profitability ratios, as many companies of this type have not yet achieved profitable operations and you cannot divide a number by zero.
Since valuation ratios rely on a company's current share price, they provide a picture of whether or not the stock makes a compelling investment at current levels. How much cash, working capital, cash flow, or earnings do you get for each dollar invested? These ratios may also be called market ratios, as they evaluate a company's attractiveness on the market.
Some valuation ratios include:
- Price/Earnings (P/E)
- Price/Cash Flow
- Price/Sales (P/S)
- Price/Earnings/Growth Rate (PEG).
Using Ratios in Financial Analysis
Examining and comparing financial ratios gives you points of comparison between companies. It also lets you track a given company's performance over time.
It's important not to base decisions on any one ratio, but rather take them together and analyze them as a whole. As such, analyzing ratios can make all the difference in your investment results, giving you the detailed information you need and helping you spot potential problem areas before you invest.