Ratios to look out for

Financial ratios can be useful in judging how well a company has performed, reports DANIEL BUENAS; Published May 14, 2007

SOME observers and market watchers say that, when it comes to investing in a company, it is really all a numbers game.

While not everyone may agree with this, it is true that a company's financials can speak volumes about how well a company is performing in the present, and is also a possible (although not always reliable) way of predicting how it will perform in the future.

And although not everyone may be numerically inclined, one way of judging how well a company has performed is through the use of financial ratios.

This week, we take a look at some of the more common financial ratios, how to calculate them, and what they say about the performance of a company.

A financial ratio often indicates a relationship between a company's various activities, like the ratio between a company's current assets and current liabilities or between its accounts receivable and its annual sales.

Most of these ratios can be derived by looking at a company's financial statements, which contain figures on assets, liabilities, profit, loss and revenues. However, these ratios are often only meaningful when compared with other information such as industry benchmarks, which help investors understand a company's performance relative to its competitors.

These ratios are also often used to track how a company has performed over time, but they do have limitations.

Always remember that, in essence, a ratio is just one number divided by another. Looking at just one - or even several - ratios may not reveal the complete story. However, when combined with knowledge of a company's management, economic circumstances, and general industry trends, ratio analysis can tell a lot about a company.

Also, there is no single correct value for a ratio, as a judgement of whether a particular ratio is too high, too low, or just OK, depends on the perspective of the analyst and on the company's competitive strategy.

A financial ratio is only really meaningful when compared with some standard, such as an industry trend. So, these ratios shouldn't be the end-all and be-all when it comes to investing in stocks, but instead are another tool investors can use when making their investment decisions.

Return on Equity (ROE)

Calculation: Net profit/Average shareholder equity for period

Measures: Profitability

Return on equity reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. A business that has a high ROE is more likely to be one that is capable of generating cash internally. Generally, the higher a company's return on equity compared to its industry, the better.

Return on Investment (ROI)

Calculation: Net profit/Total assets

Measures: Profitability

This measures the overall effectiveness to generate profits from total investment in assets. Generally, the higher the ROI the better.

Net profit margin

Calculation: Net profit/Net sales

Measures: Profitability

This measures the percentage of each sales dollar remaining after all expenses. Although, this exact ratio is highly dependent on the industry a company is operating in, generally the higher this is, the better.

Current Ratio

Calculation: Total current assets/Total current liabilities

Measures: Liquidity

An indication of a company's ability to meet short-term debt obligations, that is to say, its ability to pay current debts. The higher the ratio, the more liquid the company is. It is generally accepted that if the current assets of a company are more than twice the current liabilities, then that company is considered to have good short-term financial strength.

But if current liabilities exceed current assets, then the company could have issues with its short-term obligations.

Quick Ratio, aka Acid Test Ratio

Calculation: Total current assets minus inventory/Total current liabilities

Measures: Liquidity

This ratio is seen by some as the most stringent measure of how well a company can cover its short-term obligations. It measures a company's ability to convert current assets to cash for the purpose of meeting current liabilities.

Debt Ratio

Calculation: Total debt/Total assets

Measures: Debt management, or leverage

This ratio looks at the extent to which the total assets of the firm have been financed using borrowed funds.

Debt to Equity Ratio

Calculation: Total debt/Total stockholder's equity

Measures: Debt management

The portion of the funds obtained by the companies that came from debt vs stockholders' investments. It is important to realise that if the ratio is greater than 1, the majority of assets are financed through debt. If it is smaller than 1, assets are primarily financed through equity.