Author: Hemanth Gorur
When it comes to stock investment advice, there is no shortage of online advice, investment portals and investment apps. However, there is no substitute for doing your own preferred stock analysis and gaining first-hand insight into the value of a company’s stock.
Fundamental analysis using certain financial indicators of a company’s financial data helps with this. There are essentially two types of ratios that are relevant.
Efficiency ratios
These are financial indicators that tell us how well the company is using its resources. The asset turnover ratio tells us how well and how quickly a company generates sales from its assets.
Asset turnover ratio = Net sales / Average total assets
The inventory turnover ratio tells us how quickly a company turns its inventory into finished goods.
Inventory turnover ratio = Cost of goods sold / Average inventory
The accounts receivable turnover ratio tells us how well a company manages its collections from customers and how quickly it generates cash from loan sales.
Receivable turnover ratio = Net loan sales / Average receivables
The higher these indicators are, the higher the company’s efficiency in using its resources.
Profitability ratios
These financial ratios tell us how well a company is doing overall in terms of its financial performance and its ability to manage costs and generate income for its shareholders.
Gross margin tells us about a company’s ability to manage its cost of goods sold or cost of sales.
Gross margin = gross revenue / net sales
Operating margin tells us about a company’s ability to manage its operating costs and ensure operational efficiency.
Operating margin = operating income / net sales
Return on Equity (ROE) and Return on Asset (ROA) tell us how well a company is able to use its capital and assets to generate surplus for shareholders.
Return on equity = net income / shareholders’ equity
Return on assets = net income / total assets
The higher these ratios are, the better the company’s financial performance.
Using these ratios to discover good stocks
All of the above information is 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 at the Register of Companies (ROC) or the website of the Ministry of Economy. Jobs (MCA). Many companies calculate these ratios themselves 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 that these ratios should never be used in isolation. They must be used in conjunction with other stats, and this can be done in three ways.
First, compare these financial ratios with the historical values of the firm. A trend tells a lot more about a firm’s performance, in terms of direction and momentum, than looking at only one-year or quarterly data.
Second, compare these financial ratios to the gold standards for the industry in which the company operates. These industry benchmarks may be available in research reports, research databases, or newspaper articles.
Third, compare these financial ratios with those of the company’s competitors. Sometimes using trends over time or comparing to industry standards may not be enough. Even if a company has positive momentum as shown by its financials and is well above its industry benchmark, its competitors may be doing even better.
When all the above comparisons show the company in a good light, its stock may be a good bet for long-term investors. So, analyze these ratios carefully and take the help of an investment planning expert to take an informed investment decision.
The writer is the founder of Hermoneytalks.com.
