Analyzing Stocks with Ratios

You don't have to be Einstein or a master-of-calculus to use ratios to determine whether or not a stock is worth investing in or not.  The ratio's are surprisingly easy to use, and can give you a good indication of the potential for profitability.  Analyzing stocks with a variety of ratio's is a good way to select stocks to invest in- and definitely better than closing your eyes and picking one, or choosing a stock based on the name of the company!

There are numerous ratios that are used in evaluating stocks, but each of the financial ratios can be broken into four main categories:  profitablity, liquidity, solvency and valuation ratios.  Fortunately, each category provides a relatively simple ratio that can be used for beginning investors decision-making.

Profitability Ratio

One important aspect to be analyzed before deciding to invest in the stock of a company is that company's profitability.  If a company doesn't have the means to clear their expenses, then the result is likely to be lower dividends for investors.  It's a mistake to make your decision for investing solely on the notion that the company shows high revenues.

A profitability ratio can be used to show the likeliness of the company being able to turn a profit.  You can find this out by calculating the profit margin with a simple mathematical formula.

Profit Margin =  Net Income / Revenue

Generally, the higher the profit margin, the better the stock  but you shouldn't make a decision on the profit margin ratio alone.  If the profit margin has been decreasing for several years it might predict that a change in market or the industry is hurting the company. 

Liquidity Ratio

This ratio is a measurement of how fast the assets of the company can be converted into cold, hard cash.  The liquidity ratio gives investors a way to predict if a company is able to raise funds for growth, for repaying creditors, or for emergency situations. 

One way to judge how capable a company is for collecting debts and accounts owed to them is to calculate the receivables turnover ratio.  You can find this out with the following calculation:

Accounts Receivable turnover = Net Credit sales / Average Accounts Receivable

In this ratio, the higher the accounts receivable turnover the more frequently a company collects on debts, and a low number might indicate the company is having trouble with clients not paying.  You should compare the accounts receivable turnover from companies you are considering investing in among other companies within the same industry to get a good understanding of where your company stands.

Solvency Ratio

This category of ratio's is how investors determine how much debt a company has, and whether or not the company is likely to deal with that debt successfully over the long term.  You can calculate the total debt to total assets ratio to figure out how much of a company's assets were actually purchased with financing that is now a company debt.

Total Debt to Total Assets = (Short term debt + long term debt) / Total Assets

Generally, the closer the total debt to total assets number is to zero, the better the stock is because it shows that more assets of the company were paid for without financing (debt).

Valuation Ratio

Using ratios in the valuation category can help investors understand whether the current stock price is cheap or expensive.  The least expensive stock is generally a more attractive investment, but it depends on many factors and comparisons.

To calculate a company's stock price in comparison to the earnings the stock generates per share, you can use the price to earnings ratio.

Price to Earnings = Market Value per Share / Earnings per Share 

The price to earnings ratio will basically indicate how much investors will spend for earnings of $1.  The higher the price to earnings ratio, the more investors are willing to spend.

***Ratio Calculations from http://www.investopedia.com***