Four Ratios to Evaluate Stock Investments
Now that you have reviewed our articles on the importance of financial statements when buying stocks and have read the information on the income statement, the balance sheet statement and the statement of cash flows you are ready to interpret this data which will allow you to evaluate a potential stock investment.
A quick way to help interpret the data in these three statements is through the use of various ratios.
When using ratios to evaluate companies, you should always compare these ratios with similar companies since companies in different industries will tend to have different ratios due to the unique issues in their industry.
Although numerous ratios can be calculated, they are usually classified into four categories: efficiency ratios, liquidity ratios, leverage ratios and profitability ratios.
Efficiency ratios measure how well a company uses its assets and manages its liabilities. Common financial ratios include inventory turnover, accounts receivable turnover, accounts payable turnover and the total asset turnover. Further information on efficiency ratios.
Liquidity ratios measure the capability of a company to pay its short-term obligations (due within one year). Common liquidity ratios include the current ratio, the quick ratio, and the cash ratio. Further information on liquidity ratios.
Leverage ratios provide the investors with insight on the amount of debt a company has. The debt to equity ratio and the interest coverage ratios are two examples of leverage ratios. Further information on leverage ratios.
Profitability ratios measure the ability of a company to generate profits. Common profitability ratios include the Gross Margin, Operating Margin, Net Margin, Free Cash Flow Margin, Return on Assets (ROA) and the Return on Equity (ROE). Further information on profitability ratios.