Every day, you see the Sensex rise or fall hundreds of points. This fluctuation may worry many investors. In such turbulent times, it is important to select quality stocks. That way, you can be rest assured through the temporary ups and downs; your stock’s future is secure. So how do you select quality stocks? Simple– choose a company that is expected to grow over the next decade or so. This can be done by looking at four key financial ratios:
Nothing matters more to an investor than a company’s profits. But you often need to go beyond the final profit numbers to gauge the actual profitability. It can so happen that a company posts great profits for a short term, but is unable to do so consistently. This means its business model is not profitable. Some common profitability ratios are Profit Margins, Return on Equity (RoE), Return on Investments (RoI), Return on Assets (RoA), and so on.
A company’s profit depends on two factors- revenue and cost. It is important that companies minimize cost as much as possible to maximize profits. When a company does this, it is being efficient. There are many financial ratios which gauge this operational efficiency by comparing various costs with revenue and profits or understanding the time taken to produce goods or sell ready products. Some even measure the time taken by clients to pay money or the payment cycle for suppliers. These need to be looked at together. One single ratio cannot give the whole picture. Efficiency ratios include the Operating Expense Ratio, Inventory Turnover, Accounts Receivable Turnover, Total Asset Turnover and Accounts Payable Turnover.
Companies buy supplies, use them to produce goods, distribute it in the market, and sell to customers. This process often takes long. So, the company does not pay suppliers immediately. Similar, revenue too does not stream in immediately after sales. If the two payment cycles do not match, the company could have a cash crunch. It may then have to borrow unnecessarily, eating profits. Moreover, such a business model may not be sustainable in the long run. Liquidity Ratios like Working Capital, Quick and Current Ratios, etc, help in this regard—they measure how much cash the company has on a regular basis.
A certain amount of debt is necessary for every company-it can often signify growth and expansion. However, too much debt is bad news. It can be the death of a company. This is why it is important to understand debt. Leverage Ratios helps measure how much a company is borrowing and if it will be able to repay it. Inability to repay means high risk. Some common ratios are the Debt to Equity and the Interest Coverage ratio.
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