Over the past few months my accounting class has gone over some pretty simple, yet insightful, ways of analyzing companies profitability and liquidity. There are five main formulas I’ll go over and I think that these formulas can be very helpful when planning to invest in a company. All the formulas are based off of financial statements which can be found at Yahoo Finance or the website of the company you are researching. When doing these calculations you should always try to research what the market averages are (Ex: Target would be a retail store, so you could look up what the average values are for retailers according to each formula), that way you have a point for comparison.
1) ROA (Return on Assets): Net Income/average total assets
ROA can tell us two things: 1) It tells us, for an average value of assets, how much net income a company will yield from those assets. 2) It can also tell us the efficiency and liquidity of a company. When comparing two companies, a company with a higher ROA can mean that this company has a more productive use of assets, translating a higher percentage of net income to assets.
2) Debt Ratio: Total Liabilities/ Total Assets
The Debt Ratio tells us the risk of failing to pay liabilities. It will be a decimal below one, such that a company with a debt ratio of 0.5 means that half of their assets are financed by debt. The closer to 1 you get, generally the higher the risk because that means there is more financing through debt.
3) Current Ratio: Current Assets/Current Liabilities
The Current Ratio displays the ability to pay current debts (short term obligations) with current assets. Lets say a company has a current ratio of 2.0; this means that the company has twice as many current assets as they do current debt, which means paying their current debt should be relatively easy. If the Current Ratio is close to 1 then they barely have enough current assets to cover their current liabilities and they run a high risk of not being able to pay their current debt.
4) Profit Margin: Net Income/Net Sales
Profit Margins display the operating results (return on sales) as a percentage of profit in each dollar of sales. Lets say a company earns 15%; this means that for every dollar of sales, they earn 15 cents. The higher the profit margin, the higher the productivity.
5) Gross Margin Ratio: (Net Sales – Cost of Goods Sold)/Net Sales
The Gross Margin Ratio lets us see the gross profit per sale. If a company has a gross margin ratio of 35%, that tells us that for each dollar of sales, they yielded 35 cents gross profit. They were able to buy a product, sell it and make 35 cents.
Like I said before, it’s always a good idea to research the market norms for the companies you are looking to invest in. A good website to do this would be at Dun & Bradstreet’s Industry Norms and Key Ratios. Hope this helps with any investment decisions you’re looking to make!
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