Using Ratios to Analyze Investments 

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Ratios can be extremely helpful for making decisions about the companies you are considering to invest in. Individual investors and analysts use these ratios, which usually fall under four categories: 

  • Profitability Ratios 
  • Liquidity Ratios
  • Solvency Ratios
  • Valuation Ratios 

Let’s take a look at each category of ratios and see how to use them in analyzing investments. 

Profitability Ratios 

 

When considering a company where you want to invest, it is crucial to analyze its profitability. That’s because high revenues alone do not guarantee higher earnings or high dividends.

Generally, the analysis of profitability seeks to analyze business productivity from multiple angles with the use of a few different scenarios.

Profitability ratios help offer an insight into how much profit a company generates as well as how the profits connect to other important information about the company. 

Examples of key profitability ratios include: 

  • Return on invested capital 
  • Return on equity
  • Return on assets
  • Cash flow margin
  • EBITDA margin
  • Net margin
  • Operating margin
  • Gross margin 

Among the leading ratios that investors use to see the profitability of a company is the net profit margin, calculated by dividing net income by revenue. 

Liquidity Ratios 

 

Liquidity refers to how fast the company can repay its debts, also showing how well the company’s assets cover its expenses. 

Liquidity gives investors the idea of a company’s operational efficiency. It also shows whether the company is capable of raising cash to buy additional assets or to repay creditors quickly. 

Among the key liquidity ratios are: 

  • Working capital turnover 
  • Inventory turnover
  • Receivables turnover
  • Operating cash flow ratio
  • Cash conversion cycle
  • Cash ratio
  • Quick ratio
  • Current ratio 

Solvency Ratios 

 

Solvency ratios are also known as leverage ratios, and investors use them to get a picture of how well a company can deal with its long-term financial obligations.

A company that is weighed down with debt is, unsurprisingly, probably a less preferable investment than one with a minimal amount of debt. 

Among the most popular ratios for solvency are: 

  • Debt to total assets
  • Time interest earned 
  • Debt to equity
  • Net income to liabilities
  • Interest earned
  • Interest coverage ratio

Debt to asset and debt to equity are the two top ratios used for a quick check of a company’s debt levels. 

Valuation Ratios 

 

The valuation ratios are some of the most commonly quoted and easily used ratios for the analysis of the appeal of an investment in a company.

Such ratios mainly integrate the company’s publicly traded stock price to give investors an understanding of how inexpensive or expensive the company is in the market.

As a general rule, lower ratio levels mean the company is more of an attractive investment. Among the most popular valuation ratios are: 

  • Price-to-cash flow
  • Price-to-sales
  • Price-to-book
  • Price-to-earnings

The price-to-earnings ratio is one of the most popular valuation ratios, comparing the company’s stock price to its earnings on a per-share basis.

Like other valuation ratio analyses, the price-to-earnings ratio shows the premium that the market is willing to pay for the company’s stock.  

The ratio is calculated by dividing market value per share by earnings per share. 

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