Stock Investors: Test a Company’s Financial Strength

Choosing the right stocks for investment is about finding good stocks at the right price in order to enjoy capital appreciation and (in some cases) the income provided through dividend payments. In addition to proper valuation analysis, the investor also needs to confirm through the due diligence process that the company is financially strong; increasing its earnings, effectively leveraging its assets, managing debt properly, and positioning itself for growth and expansion. For fundamental analysts, value investors, and the like, the answers to these questions come through financial ratio analysis.

Stock investors conduct financial ratio analysis by calculating and comparing sets of numbers gathered through a company’s financial statements. The goal of this analysis is to understand the current financial condition of the company and historical trends regarding its operations. Financial ratios are divided into various categories according to the specific aspect of the company’s business it is measuring.

Categories of financial ratios include:

Liquidity: Liquidity ratios provide an indication of the company’s short-term financial situation by comparing its most liquid assets to its short-term liabilities. These ratios are run to provide the investor with comfort that the company can pay the debts it has coming due in the near-term and still fund its operations.

Leverage: Leverage ratios help understand the extent to which the company has financed its capital structure through debt. Analysis of these ratios can show the level of financial risk that the company and its shareholders are facing.

Efficiency: Efficiency ratios analyze how well the company converts sales into cash and assets into revenues. These ratios are often used for comparative purposes when analyzing two or more companies within the same industry or analyzing the company’s performance over time.

Profitability: Like efficiency ratios, profitability ratios provide investors with an understanding of how effectively the company makes use of its resources to generate profits and value for its shareholders.

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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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