5 Types of Financial Ratios

The five types of financial ratios in stock market analysis.

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Piggy Bank on Car Roof. Colin Anderson

Some financial ratios are excellent with penny stocks, while others do not work well.  In a previous article, I introduced you to which calculations work best with smaller and newer companies, and here I will delve into the bigger picture of the 5 types of financial ratios, and how they can turn your investment uncertainty into clear profits.

A financial ratio is simply one number from a company's financial results divided by another.

  When you combine various values and information, the merits (or lack thereof) of the underlying company show clearly.

For example, the fact that the share price of an investment is $2.13 tells you very little.  However, if you know the Price/Earnings ratio is 8.5, it relays much more context.  Taken a step further, you can then compare that P/E to massive corporations, direct competitors, and even to the previous results from the exact same business.

Yes, looking into many of these ratios will involve a bit of work, but most are calculated automatically for you, and displayed on all major online financial portals.  The information which you can glean from them is unmatched, and puts you at an advantage to just about every other investor out there.

Here are the 5 types of financial ratios:

Liquidity:  These ratios will demonstrate a company's ability to pay their debts and liabilities.  If they do not have enough short term assets to cover short term obligations, or they do not generate enough cashflow to cover costs, they may face financial problems.

Liquidity ratios are of extra importance with penny stocks specifically, since the tinier and newer companies have tremendous difficulties paying all the bills before their businesses become established.

Some liquidity ratios include the current ratio, quick ratio, cash ratio, and operating cash flow.

 For investors willing to gain an advantage by taking on a small amount of work, you can see summaries of the actual ratio calculations on many top websites.

Activity:  These demonstrate how efficiently the business operates.  How well does the company use the resources they have to generate sales?

There are a few great activity ratios investors should apply in their research; inventory turnover; receivables turnover; payables turnover; working capital turnover; fixed asset turnover; total asset turnover.

Leverage:  These ratios will demonstrate a company's ability to pay their long term debt.

Leverage ratios are also referred to as debt ratios; debt ratio; debt to equity; interest coverage.

Performance: Performance ratios are all about profit, which might explain why they are frequently referred to as profitability ratios.

Since most penny stocks are not operating profitably, it will not be possible to generate any performance ratio values.  You can not divide the price of shares by zero!

Performance ratios tell a clear picture of how profitable a business is at various stages of their operations; gross profit margin; operating profit margin; net profit margin; return on assets; return on equity.

Valuation:  Since valuation ratios are based on the current share price, they provide a picture of whether or not the penny stock is a compelling investment at current levels.  Basically, how much cash, or working capital, or cash flow, or earnings, do you get for each dollar invested?

Some valuation ratios include; Price/Earnings (P/E); Price/Cash Flow; Price/Sales (P/S); Price/Earnings/Growth Rate (PEG).

Take the time to learn about each of these ratios, which you can then compare directly to those of competitors, or even against the same company itself from previous quarters and years.  The added value to your understanding of a business will make all the difference in your investment results, and your clarity of trading decisions.