There are four broad categories of financial ratios; ratios that measure liquidity, efficiency, operational risk, and profitability.
Liquidity ratios measure the firm’s ability to cover both long and short-term liabilities such as the current ratio, quick ratio, and cash ratio.
It measures the firm’s ability to settle current liabilities with current assets. A ratio between 1.5 and 3 indicates strong financial performance. A current ratio of less than 1 indicates that the firm is unable to cover its liabilities, while a high ratio indicates that the firm is not investing its cash enough.
|cash + marketable securities + account receivable
It is also called the Acid-test ratio which also assess a company’s ability to pay short-term liabilities with quick assets, but the addition of receivables is to allow the firm to count among its short-term assets, and it depends on the particular context of the business.
|cash + Marketable securities
which, compare a firm’s cash and other liquid assets to its current liabilities to estimate its ability to pay off its short-term debt; there is no benchmark, bit a ratio of not less than 0.5 to 1 is preferable. The Cash ratio overestimates the value of cash and securities’ utility; a company with a lot of cash does not necessarily mean high profitability; therefore, it is the least common than the above two ratios.
While efficiency ratio shows how efficient is a firm at using its assets to generate profits giving insights to the management’s performance, and an improvement in the efficiency ratios reflects greater profitability. For banks, in particular, efficiency ratio is obtained by dividing expenses by revenues. A lower efficiency ratio reflects better operations with an efficiency ratio of 50% or less considered as ideal. To improve efficiency ratio during times of possible recessions, banks might consider laying off employees since increasing revenues would be difficult such as Wells Fargo (75.06% efficiency ratio) laying off workers of around 197 in total by July 2022. Inventory turnover ratio, asset turnover ratio, and receivables turnover ratio are three main efficiency ratios.
|Inventory Turnover ratio =
|Cost of goods sold
It assesses the business’s capacity of managing inventory effectively shedding light on the firm’s sales. It calculates the number of times the total average inventory has been sold during a certain period in order to determine whether sales are enough with respect to the inventory.
|Average Total Assets
It measures the efficiency of a company’s ability to generate sales. It indicates the amount of sales generated for every dollar in total assets. Higher ratio reflects higher efficiency of a firm’s assets while a lower one might indicate poor management. The benchmark varies depending on the industry; Industries with low profit margins typically have higher ratio while capital-intensive industries typically have a lower ratio.
|Recievable Turnover ratio =
|Average Total Assets
It assesses the efficiency of a company’s ability to collect on the credit it extends to customers. It also shows the frequency with which a company's receivables are converted to cash over a specific time frame.
Operational Risk Ratios
Operational risk ratios measure the ability of the firm to cover debt obligations. Asset Coverage ratio, cash coverage ratio, and cash flow to debt ratio are examples of the operational risk ratios.
|(Total Assets - Intagible Assets) (Current liabilities - Short term debt)
It is a solvency ratio which measures a firm’s ability to cover debt by liquidating its physical assets excluding those such as goodwill or patents, while the cash coverage ratio is the same but using the cash instead of the assets; the higher the ratio the higher the ability of the firm to meets its debt obligations indicating a less risky firm.
|Cash Flow - to - Debt Ratio =
|Cash Flow from operations
It is a coverage ratio and is used to indicate how long it would take a firm to pay off its debt if it used 100% of its cash flow. Earnings are note used since cash flow offers a more accurate assessment of a firm’s capacity to repay its debt. The benchmark ratio tends to be above 66%, and the higher the better the ratio.
Profitability Ratios evaluates the company’s ability to generate profit relative to sales or operations, balance sheet assets, or shareholders' equity. Gross Profit Margin, Return on Equity and Return on Assets are the most widely used profitability ratios.
|( Total Revenues - Cost of Goods Solid)
Gross Profit Margin measures the percentage of revenues that exceeds the cost of goods sold; it indicates the management’s effectiveness in generating revenues vis a vis every dollar of cost involved.
ROE measures the return generated from investments; it also shows how efficiently the firm is leveraging the capital it has generated by selling shares of stock.
ROA assesses how the company is using assets to produce sales and profits. A ratio of 5% or more is considered efficient, and the higher the ROA, the more efficient the management is at generating profits. Again, one should compare companies within the same sector as the ratio of an asset-heavy company would be much less than that of asset-light company to avoid any misjudgment.
What are other important ratios to analyze a stock?
Ratios could also be used to valuate stocks such as the Earnings per share (EPS), Price per Earnings ratio (P/E), Book Value per share (BVPS) and Price to Book (P/B).
The EPS, the most widely used in the financial world, shows how much a company earns in profit for every outstanding share. It is obtained through the following formula:
|Total Numner of Outstanding Shares
The Price to earnings ratio is another valuation ratio that determines the return of investor relative to what they pay for a share of the stock. Businesses with little growth prospects tend to have lower P/E ratios than those with high growth prospects.
Book Value per share (BVPS) is the sum that amount that shareholders would obtain if the company was liquidated after all the tangible assets are sold and all debt obligations are paid. A stock would be undervalued if the BVPS is higher than its current stock price, and vice versa.
|Total Equity - Preferred Equity
|Total Number of Outstanding shares
Finally, the Price to Book value (P/B) is another ratio to compare a company’s market capitalization to its book value. It shows how the market value the stock for every dollar of the company’s net worth. An undervalued stock could have a lower P/B ratio and vice versa. High growth firms tend to show P/B above 1, while a ratio below one could indicate financial distress.
|Book Value Per Share
An investor assessing a company’s financial health might consider various ratios simultaneously in comparison with the company’s own historical performance and with the industry to be able to have a well educated decision.
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