Financial ratios can give you a clear picture of the raw data of a company's finances so you can best gauge how it will perform, which will let you make prudent investment choices, whether you're looking at blue chips or penny stocks.
There are five basic ratios for stock market analysis. The data you can glean from them will give you an edge, compared to others who don't take the time to look at these figures.
What's a Ratio?
Using a 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 numbers.
Knowing that a share price is $2.13 doesn't tell you much, but knowing that the company's price-to-earnings ratio (P/E) is 8.5 provides you with more context. It tells you that when divided by its earnings per share (EPS or $0.25 in this case), its price ($2.13) equals 8.5.
You can then compare that P/E of 8.5 to those of large corporations, such as direct competitors, or even to the same company's figures from prior years, to better gauge the stock price as compared to its earnings.
Note
Many of these ratios are already performed for you and displayed on financial websites.
5 Types of Ratios
Ratios give you a picture of aspects of a company's financial health, from how well it uses its assets to how well it can cover its debt. One by itself might not give you the full picture unless it's viewed as part of a whole.
Ratios are time-sensitive by nature, because they measure data that changes over time. You should account for that when gauging them. You can gain an edge when you compare ratios from one time period to another to get an idea of a company's growth or other changes over time.
Liquidity
Liquidity ratios show whether a company is able to pay its debts and other liabilities. The company may face problems if it doesn't have enough short-term assets to cover short-term debts or if it doesn't produce enough cash flow to cover costs.
Note
Liquidity ratios are vital with penny stocks, because smaller, newer companies often have a hard time paying all of their bills before they become stable and established.
These ratios include current, quick, cash, and operating cash flow. The current ratio is current assets divided by current liabilities. 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, also called the "acid test ratio," will compare a company’s current assets minus inventory against its liabilities. It gives you a better picture of how well it can make payments on its current debts.
Activity
Activity ratios show a company's efficiency. They tell you how well the company uses its resources, such as assets, to produce sales. A few of these ratios that you might want to apply in your research include inventory turnover, receivables turnover, payables turnover, fixed asset turnover, and total asset turnover.
Inventory turnover is expressed as the cost of goods sold for the year, divided by average inventory. This can show you how well the company is managing its inventory as it relates to its sales.
Receivables turnover shows how quickly net sales are turned into cash. It's expressed as net sales divided by average accounts receivable.
Leverage
Leverage (or solvency) ratios show how well a company pays its long-term debts. These look at how much the company depends on debt for its operations, and how likely it is that it can repay its obligations. Common leverage ratios include the "debt ratio," "debt-to-equity (D/E) ratio," and "interest-coverage ratio."
The debt ratio compares a business's debt to its assets as a whole. A debt-to-equity ratio looks at its overall debt, compared to its capital supplied by investors. A lower number is often safer with this ratio, although it can imply a highly cautious, risk-averse company if it's too low.
Note
Interest-coverage ratios show how well a company can handle the interest payments on its debts.
Performance
Performance ratios tell you about a company's profit. They're often referred to as "profitability ratios." They give you a clear picture of profitability at various stages of operations. They include gross profit margin, operating profit margin, net profit margin, return on assets, and return on equity.
The gross profit margin will show gross sales compared to profits. Subtract the cost of goods sold from the total revenue, and then divide by total revenue to arrive at this number.
The operating profit margin shows a company's profits before taxes and interest payments. Divide the operating profit by total revenue.
Note
It can be very difficult to find profitability ratios when you're looking at penny stocks. Many companies of this type have not yet achieved profitable operations. You can't divide a number by zero.
Valuation
Valuation ratios rely on a company's current share price. They provide a picture of whether the stock is a good buy at current levels. How much cash, working capital, cash flow, or earnings do you get for each dollar you invest? These are also referred to as "market ratios," because they gauge how strong a company appears on the market.
Some valuation ratios include price/earnings (P/E), price/cash flow, price/sales (P/S), and price/earnings/growth rate (PEG).
Using Ratios in Analysis
Ratios give you a way to compare companies. They also let you track how a given company performs over time, but don't base your choices on any single ratio. Take them together. Look at them as a whole. Gauging ratios can make all the difference in your results, giving you the detailed data you need to spot problem areas before you invest.
Frequently Asked Questions (FAQs)
What type of financial ratio is best used to measure the ability to meet day-to-day cash needs?
The quick ratio and other liquidity ratios will tell you how quickly a business can come up with cash to meet a short-term liability. If a sudden cost arises that a company needs to cover with cash or cash-like assets, liquidity ratios will analyze a company's ability to handle that cost.
What ratio shows the after-tax earnings on a per-share basis?
The earnings per share (EPS) ratio tells you a company's net earnings per share. That accounts for taxes and other costs that could eat away at earnings. It doesn't account for taxes you'll pay on dividends and capital gains, so you'll have to take extra steps to calculate how your tax rate will affect your earnings.
