Who wouldn’t want to invest in a profitable, solvent business at a good price? This is the primary goal of any intelligent investor. However, thoroughly analyzing a company can be complicated and there’s not always enough time to do this work. Fortunately, there’s a quick and effective way to understand the key characteristics of a stock: analyzing financial ratios.

Financial ratios are simple calculations or relationships between two numbers that serve to reveal a specific aspect of a company. They are easy to interpret! In this article from Hapi, we explain the main financial ratios and how we can incorporate them into our analysis before buying a stock on the U.S. Stock Exchange.

What are financial ratios?

Financial ratios are numerical values derived from dividing two financial data points of a company. These data points come from the company’s financial statements (Balance Sheet, Income Statement, and Cash Flow Statement), or from its stock price on the Stock Exchange.

Financial ratios are used to perform a fundamental (or quantitative) analysis of a company at the levels of liquidity, leverage, profitability, and valuation. They are very helpful for making an investment. Each of these aspects will be explained in greater detail.

What are financial ratios used for in investments?

• Financial ratios are used to track the company's performance. By evaluating the trends of certain financial ratios, you can identify positive or negative trends for the company.
• They are also essential for performing comparative analysis between different companies. They help to determine whether a company is performing better or worse than the industry average.

What are the main ratios to consider when investing?

There are various financial ratios you can incorporate into your stock analysis, but to start, it’s ideal to understand the most popular ratios in depth. Another advantage of knowing these ratios is that they are the first ones to appear on most financial information platforms.

Profitability Ratios

These are the indicators of a company's ability to generate profits. These indicators often vary significantly between industries, so it’s important not to overlook the nature of the business when reviewing these figures.

• Gross Margin: This is calculated by dividing gross profits by total sales. Gross profits result from subtracting the business's revenue from the cost of goods sold.

Gross Margin = (Sales - Cost of Goods Sold) / Sales

• Net Margin: This is the ratio of net profits to total sales of a company. Net profits are the earnings after all expenses have been deducted from the revenue. This includes not only the cost of goods sold but also sales, administrative, financial, and tax expenses.

Net Margin = Net Profit / Sales

• Return on Assets (ROA): This ratio shows how efficient a company is in generating profits with its assets. An asset is a valuable resource used to generate future benefits.

ROA = Net Profit / Assets

• Return on Equity (ROE): This is a popular indicator as it shows the company's ability to generate returns for its investors. In fact, Warren Buffet and other great investors highlight the importance of this ratio.

ROE = Net Profit / Equity

Liquidity Ratios

These show the company’s ability to cover short-term and long-term debts. It’s crucial for a company to maintain liquidity to handle possible shocks and keep its debt interest rates low.

• Current Ratio: This measures the company’s ability to cover short-term liabilities with current assets (those that can be converted into cash within the same period). Regardless of the industry, a healthy current ratio is greater than one, indicating that the company is unlikely to face liquidity problems in the short term.

Current Ratio = Current Assets / Current Liabilities

• Cash Ratio: Instead of considering all current assets, this only considers cash and divides it by current liabilities. This is a more stringent ratio since it focuses solely on immediate liquidity.

Cash Ratio = Cash / Current Liabilities

Leverage Ratios

These indicate the amount of capital that comes from debt. They show how leveraged or indebted a company is. High levels of debt can be risky, making it essential to know these ratios.

• Debt to Equity Ratio (D/E): This measures the weight of debt relative to shareholders' equity. It shows how much of the company’s capital is owned versus borrowed. A high ratio may indicate that the company is over-leveraged, though some industries rely on higher levels of debt.

D/E = Liabilities / Equity

• Debt to Assets Ratio: This is calculated by dividing liabilities by assets and shows how much of the company's resources are funded by debt.

Debt to Assets Ratio = Liabilities / Assets

Valuation Ratios

These reflect how expensive a stock is relative to its ability to generate profits. Evaluating these key ratios allows you to find undervalued stock opportunities.

• Price to Earnings Ratio (P/E): This reflects how much an investor pays for a dollar of profit. It is calculated by dividing the stock price by the earnings per share (EPS). Generally, a lower P/E indicates that the stock is less expensive. However, a higher P/E can also mean that the stock is expected to grow its earnings over time.

P/E = Stock Price / Earnings per Share (EPS)

• EV/EBITDA: This is calculated by dividing the enterprise value by EBITDA. It considers the company’s debt and cash levels in addition to its stock price, relating that value to the company's earnings. Ratios vary by industry, with higher ratios expected in high-growth industries and lower ones in slower-growing sectors.

EV/EBITDA = (Market Capitalization + Net Financial Debt) / EBITDA

How to analyze financial ratios before investing in the stock market?

As you’ve seen, there are multiple financial ratios to consider before investing in a stock on the U.S. Stock Exchange. These indicators help you understand a company’s liquidity, profitability, leverage, and valuation, providing the necessary tools to find attractive stocks for your portfolio.

To find this information, simply visit your preferred financial information website, such as Yahoo Finance, Investing.com, or Market Watch, and check the statistics section for the company you're interested in.

Now that you know the key financial ratios, you'll be able to invest in financially healthy companies, giving you more peace of mind over your investments. Additionally, besides selecting strong companies to invest in, it’s essential to choose a trustworthy investment app. Hapi is a broker registered with the SEC and a member of FINRA and SIPC, ensuring your investments are protected. What are you waiting for? Start investing with Hapi today! Download the app here.