Ratios are excellent financial tools to utilize in making your investment decisions.  There are some ratios that are significantly important, and these can indicate the financial health of stocks in your portfolio. 

Using profitability ratios

Profitability ratios are important to consider when making your investment decisions, since high revenues alone do not always mean bigger dividends or increased stock prices.  Instead, profitability ratios give you an idea as to whether or not a company will create a profit based upon its financials.

One example of this type of ratio is the profit margin.  Profit margin is the company’s net income divided by revenue.  Often, the higher the profit margin the better, but you cannot look at this number alone.  You also have to look at the profit margin history, the average for the market, and the company’s competitors.  If you see the profit margin has been steadily declining, this can be a warning sign.  If the profit margin is dramatically different than the rest of the industry, it is worth the effort to discover why.  A low profit margin could mean financial distress, while a high profit margin may be unsustainable to maintain. 

The value of liquidity

Liquidity ratios show how quickly assets can be converted into cash.  This demonstrates whether or not a company will be able to raise the money it needs to pay creditors or buy new assets.

An example of a liquidity ratio is the accounts receivable turnover.  This is found by dividing the net credit sales by the average accounts receivable.   This ratio shows the number of times in a period that payments will be collected on amounts owned.  If you divide 365 by this number, you will determine the average number of days that it takes the company to collect.  The higher the number, the more frequently the company is collecting, while a lower number may mean that clients are not paying up quickly.  Again, you have to make a comparison to the rest of the industry.

Solvency ratios also show how well a company can manage long term obligations, as well as develop assets in the future.  Too much debt in the company is generally not financially sound.  Solvency ratios show you how much of the assets were obtained with debt, instead of generated revenues.  To calculate solvency ratios, add the short term and long term debt together and then divide by the total assets.  Again, you want to consider the industry, as well as the company itself.  A younger company will naturally have more debt than an older one, and some industries, such as biotechnology, have greater solvency ratios than others. 

Calculating the valuation

Lastly, you have valuation ratios, which are used to analyze the attractiveness of an investment.  It will allow you to compare how the price of the stock compares to other companies.  The less expensive a company is, the more enticing an investment it is.  For all investors, purchasing a great deal is ideal for portfolio development. 

The price to earnings ratio is one of the most familiar of these ratios.  It is calculated by dividing the market value per share by the earnings per share.  You will want to compare this number to past levels, as well as the rest of the industry.  The higher the ratio, the more investors are willing to spend.  This number works best for comparing companies in the same industry, as the P/E ratio varies across different industries.

Two other ratios to consider are return on equity (ROE) and return on assets (ROA).  ROE shows the rate at which a company’s value is growing.  It is determined by dividing the annual net income by the average shareholders’ equity.  Most investors will look for a ROE of at least 15%. 

ROA shows how much profit a company makes on its assets.  You find ROA by dividing the annual net income by total assets.  Most investors will not consider stocks with an ROA of 5% or less.  To see the clearest picture, it is best to look at both ROA and ROE to understand how effective the management truly is.

Ratios can be extremely useful to deciding which stocks you should add to your portfolio.  By taking time to figure them out, you will be able to make better financial decisions.  Ratios allow you to take the emotion out of investing, but instead profit from the financial fundamentals of a company.