Your Money | Stock vetting: Scan financial ratios first
Where stock investment advice is concerned, there is no dearth of online advice, investment portals, and investment apps. However, nothing can replace your own analysis of preferred stocks and getting a first-hand feel of the worth of a company’s stock.
Fundamental analysis using certain financial ratios of the company’s financials helps do this. There are essentially two types of ratios that are relevant.
Efficiency ratiosThese are financial ratios that tell us how well the company is utilising its resources. The asset turnover ratio tells us how well and how quickly the company is generating sales from its assets.
Asset turnover ratio = Net sales / Average total assets
The inventory turnover ratio tells us how quickly the company is converting its inventory into finished goods.
Inventory turnover ratio = Cost of goods sold / Average inventory
The receivables turnover ratio tells us how well the company is managing its collections from customers and how quickly it generates cash from credit sales.
Receivables turnover ratio = Net credit sales / Average accounts receivable
The higher these ratios, the higher the efficiency of the company in utilisation of its resources.
The gross margin tells us about the ability of the company to manage its cost of goods sold or cost of sales.
Gross margin = gross income / net sales
The operating margin tells us about the ability of the company to manage its operating expenses and ensure operating efficiency.
Operating margin = operating income / net sales
Return on Equity (ROE) and Return on Assets (ROA) tell us how well the company is able to use its equity and assets respectively to generate surplus for shareholders.
Return on Equity = net income / shareholders’ equity
Return on Assets = net income / total assets
The higher these ratios, the better the company’s financial performance.
Using these ratios to detect good stocksAll the above data are available in the company’s annual reports and audited financial statements, which should be available on the company’s website if it is a listed company, as well as with the Registrar of Companies (ROC) or the website of the Ministry of Corporate Affairs (MCA). Many companies themselves calculate these ratios and publish them as part of these reports.
The golden rule in using financial ratios to measure the attractiveness of a company’s stock is to never use these ratios in isolation. They have to be used in conjunction with other statistics, and this can be done in three ways.
First, compare these financial ratios with the historical values of the firm. A trend says a lot more about a firm’s performance, in terms of both direction and momentum, as opposed to considering just one year’s or one quarter’s data.
Second, compare these financial ratios with the gold standards for the industry in which the company operates. These industry benchmarks may be available in research reports, research databases, or news articles.
Third, compare these financial ratios with those of the company’s competitors. Sometimes, using trends in time or comparing with industry benchmarks may not be enough. Even if the company has a positive momentum as indicated by its financial ratios and is well above its industry’s benchmarks, its competitors may be doing even better.
When all the above comparisons show the company in good light, its stock is perhaps a good bet for long term investors. So, analyse these ratios diligently and take the help of an investment planning professional to take an informed investment decision.
This article was originally published in The Financial Express
