Successful investing is about managing risk, not avoiding itBenjamin Graham
Investment ratios are used by accountants, CFOs, current and future investors and among others to determine a company’s financial performance. Ratios show the story behind the numbers and can be used to pinpoint your new investment, but they are also used by a company’s management team to establish the current financial status of the firm. When used for the latter purpose, a company will act upon the results found in most cases.
Ratios can also be used to compare one company to another or to compare a company’s current performance to its past performance. These approaches might aid in choosing the right investment for you if you are eager to invest in the stock market.
In this article I will explain my 7 go-to ratios that that I use to analyze a company when I am looking for a new investment. I will not only show the calculation for these ratios, but also explain why these are important to know and what they entail.
There are several investment ratios out there, but I will stick to those I know best and use. I have this firm belief that one should always stay in their own lane and therefore I will not discuss that which I have barely any knowledge of.
The first ratio: return on equity
One of the most commonly evaluated ratios is a firm’s return on equity (ROE). The ROE shows the return generated by a business on the equity invested by the owners, during a specific period. So if you want to invest, this is the first thing you should evaluate.
The ROE can be calculated in two ways: The first way consists of only one simple formula while the second way consists of three components that let you break down the ROE further to reveal where the profit is being generated exactly. The latter is called The DuPont Framework and the three factors it consists of are profitability, operating efficiency and financial leverage.
The first way to calculate ROE is by dividing net income by the total owner’s equity for a period.
ROE = Net Income / Total Owner’s Equity
Net income can always be found on a firm’s income statement (generally at the bottom) and the total owner’s equity can be found on the right side of a balance sheet. The income statement and balance sheet are part of the company’s financial statements that can usually be accessed online by anyone, since a public company is obligated to make them available for the public.
The Dupont Framework
As mentioned before, the DuPont Framework consists of three components: profitability, efficiency and leverage. Each of these components can be calculated with their own formula, while the formula for the DuPont Framework is the following:
ROE = profitability * efficiency * leverage
Profitability reveals how much profit is left from each dollar of sales after all expenses related to the sales are subtracted. The profit margin, which shows a firm’s profitability, is calculated by dividing net income by the total sales of the period.
Profit Margin = Net Income / Total Sales
Total sales can also be found on the income statement, just like net income, and will always be at the top. Oftentimes total sales will be listed as revenue.
Efficiency can be calculated with a few different ratios, but the one I always use is the ratio for the asset turnover. A company’s asset turnover tells us how well a company is using its assets to produce sales. Initially, it may seem that the more assets a company possesses, the better. However, from an efficiency perspective, this could not be further from the truth. A business that can create more revenue with fewer assets is more efficient.
Asset turnover is calculated by dividing a firm’s revenue (sales) by the average total assets for one period.
Asset Turnover = Revenue / Assets
Again, the revenue is listed on the income statement, while the assets are listed on the balance sheet. Note that for this formula, you will need the average of assets over one period and therefore you will need the beginning and ending balance sheet amounts.
The last factor to calculate is the leverage. The financial leverage is also known as the equity multiplier and measures the impact of all non-equity financing, or debt of all sorts, on the firm’s ROE. If all of the assets are financed by equity, the multiplier is 1. As liabilities increase, the multiplier increases as well, demonstrating the leverage impact of the debt.
While increased leverage has the potential to increase returns as well, it also increases the riskiness of the investment. When a business makes a loss, the debt amplifies the impact of the loss on equity holders. Moreover, if the business were to fail, debt holders would receive the money back before any money is paid out to the equity holders.
The financial leverage is calculated by dividing the average total assets by the average total equity for one period.
Leverage = Average Total Assets / Average Total Equity
There are two more ratios that I like to use when I am establishing a company’s financial performance: the current ratio and the quick ratio. These ratios might as well be the most well-known ratios and an investment platform like eToro always lists these ratios in a company’s analysis.
The current ratio aids in understanding the firm’s ability to pay its short-term debt and obligations and is calculated by dividing the current assets by the current liabilities.
Current ratio = Current Assets / Current Liabilities
If current assets are smaller than current liabilities, which would lead to a ratios less than 1, it could indicate that a business may have trouble meeting its obligations in the near future.
Generally, the higher the current ratio, the better position the business is in to meet its upcoming liabilities. But if the current ratio is too high, it might indicate that the business is not managing its working capital efficiently.
The quick ratio, also known as the Acid Test, is similar to the current ratio, but only highly liquid assets are used in the calculation. A highly liquid asset is an asset that can be converted into cash in a very short period of time. So whereas inventory is included in calculating the current ratio, it is left out when calculating the quick ratio.
The Acid Test is an even more accurate test to see if a company is able to meet its short-term responsibilities, because it depends only on the most readily available current assets. The Acid Test takes into account the possibility of inventory not directly being converted into cash.
The quick ratio is calculated by dividing the total of current assets after subtracting the inventory by the current liabilities.
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
When the quick ratio differs a lot from the current ratio, it is an indicator that a business is dependent on its inventory to sell. An example would be H&M, whose current ratio is much higher than its quick ratio. These are respectively 1,14 and 0,46.
How to interpret ratios
One way to get the most out of these ratios is to not only calculate them for one specific period of time, especially not during a crisis. To get an ultimate overview of a company’s performance, I would suggest to look at their past as well. The past will indicate if a company is stable, growing or in decline.
When looking for an investment, I would not make a decision solely based on ratios. Although these ratios provide a great insight, there are several other factors to consider as well. These factors might include the industry a firm is operating in, their competitors and upcoming announcements, launches or releases.
Lots of love,