Key financial ratios you must look at before making an investment

Investing with moomoo joined discussion · Jul 6, 2021 15:21

Key financial ratios you must look at before making an investment

Stock investing requires careful analysis of financial data to find out the company's true worth.
Key financial ratios allow investors to convert raw data(from financial statements) into concise, actionable information. This information is used to evaluate a company's performance, compare companies, industries and conduct fundamental analysis.

In this article, we will take a glance into a company's liquidity, operational efficiency, and profitability ratios to reveal insights regarding the company's performance.

1. Liquidity ratios

Liquidity ratios measure a company's ability to meet short-term debt obligations without raising additional capital. Liquidity ratios include the current ratio, quick ratio, and working capital ratio.

The current ratio is calculated by dividing current assets by current liabilities.
The quick ratio is calculated by dividing liquid assets by current liabilities.
The working capital ratio is calculated simply by dividing total current assets by total current liabilities.

2. Solvency ratios

Solvency ratios also called leverage ratios, measure the amount of debt a company incurs in relation to its equity and assets to evaluate the likelihood of a company staying afloat over the long haul, by paying off its long-term debt as well as the interest on its debt.

Solvency ratios include debt-equity ratios, debt-assets ratios, and interest coverage ratios.
Debt-equity ratios are calculated by dividing total liabilities by total shareholders' equity.
Debt-assets ratios are calculated by dividing total liabilities by total assets.
Interest coverage ratios are calculated by dividing the company's EBIT by its interest expanse.

3. Profitability ratios

Profitability ratios measure a company's ability to generate earnings in relation to its revenue, operating costs, shareholders' equity and the balance sheet assets. They include Profit margin, return on assets, return on equity, return on capital employed, and gross margin ratios.

Profit margin is calculated by dividing net income by revenue, then multiplying by 100.
Return on assets is calculated by dividing net income by total assets, then multiplying by 100.
Return on equity is calculated by dividing net income by shareholders' equity, then multiplying by 100.
Return on capital employed is calculated by dividing EBIT by capital employed where EBIT equals the earnings before interest and tax, and capital employed equals total assets minus current liabilities.
Gross margin ratios are calculated by dividing the difference between total revenue and COGS(cost of goods sold) by Total revenue, then multiplying by 100.

4. Efficiency ratios

Efficiency ratios measure a company's ability to use its assets and liabilities to generate sales and maximize profits. Key efficiency ratios include asset urn over ratio, inventory turnover, and days' sales in inventory.

The asset turnover ratio measures how efficiently a company generates sales from its assets. It is calculated by dividing net sales by average total assets.
The inventory turnover measures the number of times a company sells its inventory within a given period. To calculate the inventory ratio, divide the cost of goods sold by average inventory.
Days' sales of inventory are also known as the average age of history. This figure represents how many days a company's current stock of inventory will last. It is calculated by dividing average inventory by cost of goods sold, then multiplying by 365(days).

5. Coverage ratios

Coverage ratios measure a company's ability to make the interest payments and other obligations associated with its debts. Coverage ratios include times interest earned ratio and the debt-service coverage ratio.

The times interest earned ratio measures a company's ability to meet its debt obligations based on its current income. It can be calculated by dividing a company's EBIT by its periodic interest expense.
Debt-service coverage ratio measures the ability of a company to use its operating income to repay all its debt obligations, including repayment of principal and interest on both short-term and long-term debt. It is calculated by dividing net operating income by total debt service, where total debt service equals current debt obligations.

6. Market proespect ratios

These are the most commonly used ratios in fundamental analysis. They include dividend yield, P/E ratio, earnings per share, and dividend payout ratio. Investors use these metrics to predict earnings and future performance.

While financial ratio analysis helps in assessing factors such as profitability, efficiency and risk, added factors such as macro-economic situation, management quality and industry outlook should also be studied in detail while investing in a stock.