The 5 Types of Financial Ratios
All ratios have their best application, and while some financial ratios work well with penny stocks, for example, others don't offer much useful information. In the bigger picture of ratios, five general types of financial ratios exist, and you can learn how they offer the types of insight that can turn your investment uncertainty into clear profits.
What's a Ratio?
Simply put, a financial ratio means taking one number from a company's financial results and dividing it by another. When you combine various values and information, the underlying company's merits, or lack thereof, show clearly, especially when you compare ratio results over time or to the company's competition.
For example, an investment's share price of $2.13 tells you very little. However, if you know the company has a Price/Earnings (P/E) ratio of 8.5, this provides you with more context. Taken a step further, you can then compare that P/E to large corporations, direct competitors, and to the previous results from the exact same business for even more insight.
Looking into many of these ratios involves some work, but you can find many calculated for you and displayed on several major online financial portals. The information you can glean from them is unmatched and puts you at an advantage to other investors who don't do their due diligence.
The 5 Types
- Liquidity: These ratios demonstrate a company's ability to pay their debts and other liabilities. If they do not have enough short-term assets to cover short-term obligations, or they do not generate enough cash flow to cover costs, they may face financial problems.
Liquidity ratios hold extra importance 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 the current ratio, quick ratio, cash ratio, and operating cash flow margin. For investors willing to gain an advantage by getting to know these ratios, you can see summaries of the actual ratio calculations on many top websites.
- Activity: These ratios demonstrate how efficiently the business operates. In other words, you can see how well the company uses its resources, such as assets available to generate sales.
A few great examples of activity ratios investors should apply in their research include inventory turnover, receivables turnover, payables turnover, working capital turnover, fixed asset turnover, and total asset turnover.
- Leverage: These ratios demonstrate a company's ability to pay its long-term debt. Leverage ratios are also referred to as debt ratios, debt-to-equity ratios, and interest-coverage ratios.
- Performance: Performance ratios tell investors about profit, which explains why they are frequently referred to as profitability ratios.
Since most penny stock companies have not yet achieved profitable operations, it won't 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 a company's profitability at various stages of its operations, such as gross profit margin, operating profit margin, net profit margin, return on assets, and return on equity.
- Valuation: Since valuation ratios rely on a company's current share price, they provide a picture of whether or not the penny stock makes 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), and Price/Earnings/Growth Rate (PEG).
Ratios in Use
Each ratio itself doesn't offer much information. However, once you learn about each of these ratios, you can then compare them directly to those of your target company's competitors, its industry averages. or against itself from previous quarters and years. This provides insight and value to your analysis and understanding of business. It can make all the difference in your investment results, and offer much more clarity to your trading decisions.