Understanding Basic Financial Ratios Part One

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One of the most common ways to grow your wealth is through the buying and selling of stocks and shares. Of course, you shouldn’t buy blindly. This article will examine one of the ways you can evaluate the strength of the company.

I skipped some of my ratios lectures in college and over the years I learned to regret it somewhat. Ratio analysis is an approach that some investors and analysts use to compare the strengths and weaknesses of various companies. It is one of the most widely-used fundamental analysis techniques.

Ratio Analysis

financial ratios analysis

Just with any technique, you do need to understand how to properly use ratio analysis and not treat it as if it is a magic bullet. For example, you should not be comparing different types of companies from different sectors and industries.

There are many types of financial ratios. To make things less confusing, we have created these categories – activity ratios, liquidity ratios, solvency ratios, and profitability ratios.

Activity Ratios

When you talk about activity ratios, you are examining how well a company uses its assets. For you, the intrepid invester, you get to gauge the overall operational performance of the organisation. This includes finding out how many times a year inventory is replenished or how quickly receivables are collected.

Asset turnover

This measures how well the firm will use all of its assets to generate its incomes. You just divide the net revenues by the average total assets to get the asset turnover. If the company has a ration of 0.1x, then it means that it generates $0.10 for every $1 of assets it owns.

Payables turnover

This measures how quickly the company pays its suppliers. You get this number by dividing purchases by average payables.

Inventory turnover

A higher inventory turnover as compared to the industry average means that the company’s inventory is being sold much faster, which in turn could mean that it is managing its inventory very well. This number is calculated by dividing the cost of goods sold by average inventory.

Receivables turnover

This measures how fast a company is able to collect on its outstanding bills. Obviously, this is important as it is a gauge of the health of the company’s cashflow. You can get this financial ration by dividing the company’s net revenue by average receivables.

 

Profitability Ratios

This is probably the most popular financial ratios. If you have ever dabbled in business, you would understand the ratios that include gross, operating and net profit margins. You use these ratios to understand how well the company earns an good return on its income. Compare them to others in the same industry or to their closest competitors.

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Gross profit margin

You calculate gross profit margin by diving gross income by net revenue. This number will help you understand the company’s judgement when it comes to pricing factors and product costs. If the gross margin is 30%, it means that 30% of the revenues of the company are needed to pay for the costs of the goods sold.

A higher gross profit margin may mean that the company has a competitive advantage. This is because for matured industries, the more competitors enter the market the worse the gross margin is. If the company is a first mover though, do be wary if competitors start entering the market.

Operating profit margin

Operating expenses such as administrative overheads, rental and others than cannot be attributed to single product units can take a big toll on a company’s profitability. The operating profit margin provides investors with an insight of the relationship between sales and the costs that can be controlled by management. This is derived by dividing the company’s operating income (gross minus operating expenses) by the net revenue.  If it has an operating margin of 28%, this means that for every $1 of revenue, $0.28 is left after you minus off the COGS and operational expenses.

Net profit margin

When you divide a company’s net income by its net revenue, you are measuring it’s net profit margin. This will determine how well the company is able to turn the sales it generates into dividends that it can pay its shareholders. If you’re going to invest in shares, then you as a shareholder would want to find companies that can provide you with good returns. If a company has a net profit margin of 1.1%, it means that for every $1 revenue created, it will provide $0.011 value to its shareholders.

We will look at liquidity and solvency ratios in my next article.

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