Before choosing which stock to add to your investment portfolio, it is important to look at a company’s financial performance to help determine whether it is the right investment for you.
There are five basic groups of ratios to focus on that will give beneficial insight into a company. The ratios can help reveal the profitability and quality of a business.
What are the five major categories of stock analysis ratios?
Liquidity ratios show a company’s ability to pay off current debt obligations due in the next 12 months without raising outside capital, taking on a loan, or making extreme operating cuts.
This can help identify how the business is performing. Higher values for liquidity ratios indicate the company is better able to cover its near-term debts. Low liquidity ratios can mean the company could (or is) facing a cash crunch, which could result in the company having to make poor long-term decisions in order to survive (e.g., raising expensive or restrictive capital, not continuing to make the right investments, etc.).
The ratios are most useful when comparing them against the company’s own financial history or vs. industry peers. Self-comparisons provide insight into whether the company is in a better or worse position vs. its historical one; industry comparisons give information about its relative strength compared to its competition.
Solvency or Leverage
Solvency ratios, also sometimes referred to as leverage ratios, focus on a company’s long-term ability to pay off all of its current and future debts. Most solvency ratios look at the company’s overall debt burden relative to its assets or shareholder equity. The higher the relative debt burden, the bigger the company’s risk.
Some companies operate in highly debt-intensive industries, so it’s important to look at today’s solvency ratios relative to the company’s own history of debt and as compared with industry competitors.
Still, even if all companies in an industry have high debt burdens, that doesn’t mean it’s OK — just look at airlines during the COVID pandemic or auto makers during the Great Recession!
Profitability ratios show a company’s ability to produce profit and value for shareholders and to reinvest in growth for more future profit. These are probably the best overall measures of a company’s health.
Profit can be measured in a number of ways, from Net Income and Operating Earnings/EBIT to Free Cash Flow or even Gross Margin. These are then compared to revenue/sales, but can also be looked at versus balance sheet assets (e.g., ROA), operating costs, or shareholders’ equity (e.g., ROE). It is typically preferable to have higher ratios, but comparing them to other companies or with its own internal financial history gives a better view.
Efficiency ratios look at how well the company converts its most liquid assets — inventory and receivables — back to cash, and how long that overall process takes.
Some businesses collect cash up-front and pay suppliers much later, which is a great model. Some businesses have to fork over cash for inventory many months before they collect on it, which requires much more capital when growing. Understanding this aspect of a potential investment is critical.
The quality ratios we like are composite metrics that combine a lot of different stats that were developed to predict stock market outperformance, bankruptcy risk, and earnings manipulation. These can be helpful for getting an overall view into the quality of the business. You should still look at the details, and some companies that appear to be high quality may still not be good investments, but these can be very helpful for quickly screening lots of opportunities.
Here are some examples of each kind of ratio:
- Free cash flow (FCF) to short-term debt reveals whether the company’s most recent cash flows could pay off the debt that’s due in the next 12 months. The higher the cash-flow-to-debt ratio is, the more breathing room the business has if something unexpected happens or if the business needs to take on more debt.
- Current ratio: this is simply current assets divided by current liabilities, and is another way to look at a company’s ability to pay its upcoming bills with its most liquid assets.
- Quick ratio: this is the same as the current ratio but excludes inventories from the numerator. For many companies, inventory is not as liquid as receivables and cash, and for whom having a huge amount of unsold inventory would be a problem. You can think of this as a more conservative version of the current ratio.
- Debt to equity compares a company’s total debt to total shareholders equity. When this leverage ratio gets too high, it can mean the business has taken on too much debt and may be faced with the possibility of being unable to meet the obligations on its loans or bonds.
- Cash return on invested capital (CROIC). This shows how a business generates cash returns on its investments, by looking at how much Free Cash Flow it can generate annually compared to the total amount of capital that has been invested in the business. Businesses that can generate tons of cash relative to capital are highly attractive, if they are sustainable. Ensuring CROIC is higher than the cost of capital for the business is also essential.
- Free cash flow to sales (FCF/S) reveals what percentage of sales ends up as free cash flow. Free cash flow measures the amount of cash a business earns after subtracting operating costs and reinvestment (including increases in working capital needs and capital expenses, such as building and equipment), as well as adjusting for non-cash expenses like depreciation. The higher the percentage of sales winding up as FCF the better, obviously, but the reason we like Free Cash Flow more than Net Profit is because it’s a better measure of the business’s true bottom-line returns.
- DuPont Return on Equity (ROE) is a model used to find what causes the return on equity. Return on equity indicates a firm’s ability to generate returns for shareholders, which is what you are thinking about becoming. Understanding what drives this can be illuminating.
- Cash conversion cycle is a cash flow calculation. It finds how many days it would take a company to convert its inventory into cash flows from sales.
- Inventory turns measures the number of times inventory is sold or used over a certain time period. It shows how well a company manages its stock.
- Accounts receivable turnover is a ratio that measures how efficiently a company collects revenue.
- Piotroski F Score is a 9-point scoring system that determines the strength of a company’s financial position. The score can help investors find the best value stocks. A higher score is better.
- Altman Z Score is a score used for predicting whether a company will go bankrupt. It is based on a formula using five ratios derived from a company’s income statement and balance sheet.
- Beneish M Score is a mathematical model that uses financial ratios and accounting data to find whether a company’s earnings were manipulated.
What ratios should investors look at?
While looking at a company’s overall picture might be the best way to forecast how it might perform in the future, here are some of the more valuable ratios to consider when seeking a snapshot of a company’s performance:
- Liquidity should be considered as it essentially shows a company’s ability to pay its bills. A poor liquidity ratio puts a business at risk for bankruptcy.
- Solvency is helpful in understanding a company’s overall level of indebtedness, and whether it might be so high that it might not meet its obligations and, again, face bankruptcy. For instance, this can show whether the company will remain strong during an economic downturn. Debt-to-equity is a key ratio to look at under solvency.
- Inventory turns, accounts receivable and DuPont ROE also are important financial ratios for investors to calculate.
What is ratio analysis and its types?
Ratio analysis uses financial ratios to gain insight into a company’s historical financial performance and predict future performance.
Examples of the types of ratios used include liquidity, profitability, activity, debt, market, solvency, efficiency and coverage.
How do you calculate ratio analysis?
Details such as a company’s operational efficiency and liquidity can be found by reading financial statements, including the balance sheet. To better understand a company’s performance, ratio analysis is used to compare a company to another within its industry.
Looking at financial ratios is a key step to take when considering where to invest your money. They can help discern the health of a business and whether purchasing its stock is an investment you want to make.