If you’re a new investor, the wealth of information that’s available to you about the average company may seem overwhelming. Often we hear analysts talk about financial ratios and jargons that may seem complex and intimidating. In this article, I aim to simplify these complexities into a set of financial ratios that you can rely on when analysing financial statements to help you understand companies better.
I remember the first time I tried to analyse a financial report, I was really stumped on how and where to begin reading it. A typical 100-page annual report can consist of vast information such as the chairman’s statement, directorship announcements and declarations, financial position, shareholders ownership and etc.
However, through a proven process of fundamental analysis, you can learn exactly how to make sense of all the facts and figures at your disposal.
This evaluative method is the key to making rational investment decisions because it can help you understand the true financial position and growth potential of any business you may be considering as an investment.
When we examine a company, our goal is to arrive at a well-considered valuation of the company’s stock. To accomplish this, we have to consider not only the financial figures of the company but also factors such as competitive positioning in the marketplace and the quality of its management team.
One of the essentials of fundamental analysis is a process known as financial ratio analysis. Ratio analysis is simply a mathematical tool that you can use to translate and clarify the financial data and compare financial figures with one another. This process will help you understand a company’s financial health today and its potential for growth and positive performance tomorrow.
It is vital that you recognize the importance of fundamental analysis and that you become familiar with the ins and outs of financial ratio analysis. This process can help you find value in a business and you can also use financial ratios to detect fraud and problems in any business that you want to invest in.
We have a total of 5 main categories of financial ratios, which consist of profitability, efficiency, solvency, financial liquidity and valuation. Now let’s take a look at each of these categories to see how they contribute to the overall value of your fundamental analysis.
One of the most important aspects of analysing a company is to measure its profitability. Profitability ratios are calculations used to determine how profitable a business is.
As its name implies, a profitability ratio simply measures your company’s ability to generate profits from its core business operations.
There are 2 ways of measuring the profitability of a company, in absolute or relative terms. Say a company reports its full-year earnings as $10 million, this is reported in absolute terms, where profits are not compared with other financial figures in the financial statements. When analysing a company, it is important for us to measure its profitability in relative terms. This will provide some perspective on the current operating profitability of the company.
There is a wide range of ratios for measuring just how profitable a company is, but the majority of them are designed to compare firms profits against factors such as its total revenue, assets and its shareholder’s equity. Profitability ratios are versatile as it reflects the firm’s efficiency, solvency, management ability, and overall financial performance.
Ideally, we want to look for companies that are growing their Margins (Operating/Net) and Return on Equity. Look out for companies that are declining in Margins as it may suggest that their operating business is deteriorating.
2. Financial Liquidity
Liquidity is the term used to describe how quickly and easily a company can convert its assets into cash. This is an important factor to consider because the more liquid a business is, the better its ability to pay off its short term debts.
A company may have a lot of assets including money owed by customers, inventories, property, and investments. However, if the company can’t easily turn those assets into cash when necessary, it could have trouble funding its day to day operations or meeting unexpected financial obligations.
When you use a liquidity ratio to analyze a business, you’re basically determining its ability to cover its short term debts and this can give you some idea of how successful it will be in continuing its current operations.
Examples of liquidity ratios you may run across include the current ratio, the quick ratio and the operating cash flow ratio.
The higher the result of any of these ratios the more liquid a company is and the more capable it will be of keeping it short term debt payments under control.
The third type of ratios that we’re going to discuss are solvency ratios. The term solvency refers to a company’s ability to meet its long term liabilities as opposed to a short term debt.
A company is described as solvent when it has the ability and resources to fund its ongoing financial obligations. Solvency ratios measure a company’s total debt against the income it earns, assets it owns or shareholder’s equity. Common solvency ratios include the interest coverage ratio, debt to EBITDA and debt to equity ratio.
The interest coverage ratio measures the total interest expense as a proportion of operating profit. A high number would suggest that the company would not be burdened by interest payments. On the other hand, Debt to Equity and Debt to EBITDA measures its long term debt as a portion of its Shareholder’s equity and Earnings respectively. Generally, we want to look for companies that have a low debt to equity or EBITDA.
A major competitive advantage of a business is how efficient they are at using assets and debt to produce profits. To measure this, we use efficiency ratios to measure the operational efficiency of a business.
Efficient businesses generate more profits than its competitors, they are able to capitalise on the excess profits to reinvest in the business and in turn generate even more profits in the future. Much of what you learn from a firm’s operational efficiency reflects on the quality of its management team.
As an example, certain efficiency ratios can measure a company’s assets against its earnings or measure how well a company generates sales from its inventory. In both cases, it shows a good picture of how efficiently a business is being run.
The asset turnover ratio shows you how successfully the business is using its assets to create profits. The larger the number, the more efficient the business is at utilizing its assets.
On the other hand, the inventory turnover ratio demonstrates how well the company manages costs and how effective their sales efforts have been. The larger the number, the more efficient the business is at utilizing its inventory.
Once you’ve found a suitable stock to invest in, you now have to purchase them at the right price, which brings us to the final type of financial ratio, the business valuation ratio.
When you perform a business valuation, you’re essentially estimating the economic value of a given company. This estimate provides you with a snapshot of the company’s current financial standing and can help you determine how much its shares are worth.
Business valuation ratios are particularly useful for comparing companies within the same market sector or within the entire market as a whole. They define how cheap or expensive an investment is in terms of its potential for profit.
The most common business valuation ratio is known as the price to earnings ratio which measures a firm’s current share price against its earnings per share.
This calculation shows you how much money investors are willing to pay for each dollar that a business is generating and earnings overall.
When you want to compare just how expensive or cheap a particular stock is in comparison to its competitors or to the stock market as a whole, business valuation ratios are the way to go.
In the world of investing, these 3 ratios are also known as relative valuation. Generally, the lower the number, the cheaper a stock is relative to its earnings, assets or cash flow.
As you can see financial ratio analysis is a very broad topic.
There are dozens of financial ratios out there.
But the thing is that not all of them are useful.
That is to say, using a lot of financial ratios at the same time will lead to a less useful valuation result.
So you don’t need to learn every single ratio to truly evaluate a company.
You just need to learn a handful of financial ratios which will help you significantly in your evaluation process.