Financial Ratios and Fundamental Analysis

Financial ratio analysis is one of the most important aspects of the fundamental analysis process. Through ratio analysis, an investor can systematically sort through and make sense of the volumes of financial statement data offered by a company. By analyzing and monitoring a company’s financial ratios, an investor can gain insight into the financial strength of a company and how effectively that company is being managed.

Fundamental analysis is an approach to investing under which the investor evaluates an investment in a stock by measuring its “intrinsic” value. In conducting this analysis, the fundamental investor will examine the company’s financial statements, economic and industry-related factors, and more qualitative factors (like the quality of the company’s management team) in an effort to assign an intrinsic value tot the stock. The investor can then compare that intrinsic value to the current share price to determine attractiveness of the investment.

Financial ratios are powerful tools for fundamental analysts, enabling them to make sense of key parts of a company’s financial statements.

Profitability ratios are used to assess the company’s ability to generate earnings in comparison to its expenses over a specific period of time. Profitability ratios measure a company’s ability to increase shareholder value and generate profits. A company with a higher profit margin than its competitor is seen as more efficient. Profit margin, operating margin, and gross margin are examples of profitability ratios.

Asset turnover ratios are used to illustrate the relationship between the company’s assets and the revenue it generates. Asset turnover provides an indication of the company’s efficiency in using leveraging it assets. The higher the measure the better and, ideally, the company shows improvement in this measure over time.

Liquidity ratios offer measurements that help determine a company’s ability to pay off its short-term debt obligations. A high liquidity ratio can indicate a significant margin of safety for covering these short-term debts. A low measure can mean that the company will have difficulty maintaining its operations and satisfying these obligations. The most commonly used liquidity ratios include the cash ratio, the current ratio, and the quick ratio.

Leverage ratios, like the debt-to-equity ratio, demonstrate the degree to which the company is leveraging itself through the use of borrowed money. Unlike liquidity ratios, financial leverage ratios measure the extent to which the company is using long-term debt. High leverage ratios can provide an indication to both potential lenders and investors that the company might be headed for financial difficulty.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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