Ratios – Another Way to Analyze Investments

Fraud, Misrepresentation and Negligent Supervision FINRA Arbitration and Litigation Attorney, Russell L. Forkey, Esq.

There are a number of well-known methods that investors us to analyze potential investments. Certain of these techniques have been discussed in other areas of this website. One such system is through the use of ratios. However, please keep in mind that the information provided in the post is not complete in all material respects. It is for educational purposes only. Thus, it should not be relied upon as legal or investment advice. If you have any questions relative to the information provided in this post, you should contact a qualified professional.

There are a number of types of ratios that are available for use, but financial ratios can be broken down into four major categories. They are solvency ratios, liquidity ratios, profitability ratios and valuation ratios.

Solvency Ratios

Solvency Ratios can be used by investors to determine how well a company can deal with its long-term financial obligations and create future assets. The total debt to total assets ratio is used to determine how many of a company’s assets were paid for with debt. Total debt to assets is calculated by dividing total assets into short- and long-term debt.

When using a solvency ratio, it can be very helpful to look at the company that you are examining as well as making industry comparisons. Other solvency ratios include times interest earned and free cash flow.

Liquidity Ratios

Liquidity is a measure of how fast a company’s assets can be turned into cash. Liquidity ratios provide investors with some idea of how capable a company will be in raising money in any number of potential scenarios. Some forms of liquidity ratios are receivables turnover, working capital turnover and inventory turnover.

For example, accounts receivables turnover ratio is determined by dividing net credit sales by average accounts receivable.

Profitability Ratios

Profitability is obviously an important piece of information that should be looked at when you are considering investing in a company. This is because it goes without saying that high revenues alone do not necessarily translate into dividends for investors or increased stock price.

One example of an important profitability ratio is the company’s profit margin. Profit margin is calculated by dividing net income by revenue. Other profitability ratios include gross margin and operating margin.

Valuation Ratios

Valuation ratios can be used by investors to gain an understanding of how cheap or expensive a company’s current stock price is compared to a number of different measures. Profitability ratios include price to earnings ratios, price to sales ratios, price to book ratios and price to cash flow.