Picking the best stocks requires you to use a little bit of accounting. At first it may be confusing but once you use these ratios and read a few financial statements it becomes very simple. The financial statements consist of the balance sheet, cash flow, and income statement. You don't need anything more than basic math skills to understand the ratios listed below.
1. Current Ratio - This ratio is really useful in determining the short term health of a company. It is calculated by taking current assets / current liabilities. This two numbers are found on the balance sheet and represent one year until they are due. A good rule of thumb is a Current ratio around 1-1.5 although this number differs greatly depending on the industry.
2. Asset Turnover - A company's operations and growth potential comes from their assets. Asset turnover is calculated by revenue / total assets. It shows us the assets efficiency and if they company's expenditures result in higher revenue. If a company's assets are growing every year but its revenues don't change it can mean that the business is unable to invest its money properly.
3. D/E Ratio - The Debt to Equity ratio shows us how a company finances its operations. Calculate by total debt / total equity both of which are located on the balance sheet. It is important to realize that some debt isn't bad due to its tax advantage. Only when the debt becomes overbearing that it can have bad indications for investments. Look at the companies competitors and industry to get a better feel what a good D/E ratio is for that particular stock.
4. Profit Margin - Net income / Revenue shows the efficiency of a company. This is very intuitive but it is the percentage of money left over after all expenses are paid. Make sure you understand the type of company before comparing multiple profit margins. Retail companies typically have low profit margins while tech companies have very high margins. Comparing the 2 strictly on this ratio would create a poorly diversified portfolio.
5. P/E Ratio - The price to earnings ratio is a very interesting ratio because it takes the current stock price / net income. This is a great ratio to analyze companies and whether their stock price makes sense compared to the amount of money they are able to generate. If you browse around you will find a lot of stocks with really high P/E ratios indicating that people will pay a hefty premium compared to other companies.
Make sure to use all of these ratios together along with the many others that I didn't list. Using these ratios in context with the respective industry and sector is imperative for you to make any sense of the numbers. Alone these ratios mean nothing but in respect to the overall stock market they tell you almost everything you need to know.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.