5 Types of Financial Ratios for Evaluating Stocks

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By using financial ratios, investors can explore various pieces of facts in the financial statement of a company and consists of calculating ratios from the financial statements. Market analysts mainly use it to define various aspects of a business, such as liquidity, profitability, and solvency.

The analysts mainly depend on the present and previous financial statements, such as net income, to get hold of data to evaluate the company’s economic performance.

The data is used to determine whether the company’s financial status is growing upwards or downwards and comparing it with other business rivals.

What are the uses of ratio analysis?

Predicting Trend Lines

Companies use financial ratios to determine the trend in their business’s financial performance. Reputable companies collect information from their financial statement over a long period of reporting. The proven trend can be used to forecast the future direction of the financial performance and identify potential economic instability that would otherwise be difficult to predict while using ratios from a single reporting time frame.

Comparison

Another use of financial ratios are to make financial performance comparisons between firms in the same industry to understand where the company stands in the markets. Obtaining a competitor’s financial ratios such as their price or earnings and comparing it to one’s company ratios can help the management identify gaps and examine its weakness, strength, and competitive advantage. The administration can utilize the information obtained to develop decisions that will help stir the company’s market position in the right direction.

Determining Operation Efficiency

The management can use financial ratios to determine the efficiency of the business’ assets and liabilities. Uneconomical usage of assets such as land, buildings, and motor vehicles leads to unnecessary expenses that need to be purged. Asset ratios can also be used to ascertain whether financial assets are under-or over-utilized.

Categories of Financial Ratios

Price Ratios

Also commonly referred to valuation ratios or market ratios, price ratios measure a company’s stock price by providing look into the fair market value of the stock to determine whether it is under or overvalued.  It does that by evaluating cash, working capital, cash flow, and earnings.  Investors use them to foresee future performance and earnings. It includes dividend yield, dividend pay ratio, earnings per share, and price to earnings ratio.

Profitability Ratios

The profitability ratio helps to put forward how an entity can generate profits through the company’s operations. Examples include return on capital employed, profit margins, gross margin ratios, return on assets, and return on equity,

Liquidity Ratios

These ratios tell the company’s capacity to settle the short-term debts when in arrears, using the quick and current assets.

The quick ratio, the current ratio, and the working capital ratio are all examples of liquidity ratios.

Efficiency Ratios

Also identified as activity ratios, it helps gauge how well a company employs total assets and liabilities to make sales, capitalize on revenues and receivable turnover. Turnover ratio, days’ sales in inventory, and inventory turnover are vital efficiency ratios.  Inventory turnover is represented by the cost of goods sold for the year divided by inventory.

Debt Ratios

Also commonly referred to as coverage ratios, debt ratios are used to gauge a company’s long term debt and its ability to pay interests and other payments associated with the debt. These include the debt-servicing coverage ratio and times interest earned ratio.

Financial statements are incapable of providing information on their own. Information contained inside these statements needs a proper context to better understand the various aspects of a company’s financial health. One method investors can use to gain such an understanding is by the use of financial ratio analysis.


Chris Douthit
Chris Douthit

Chris Douthit, MBA, CSPO, is a former professional trader for Goldman Sachs and the founder of OptionStrategiesInsider.com. His work, market predictions, and options strategies approach has been featured on NASDAQ, Seeking Alpha, Marketplace, and Hackernoon.