“Rich people make their money work for them while poor people work for money.” This slogan is commonly used in financial coaching classes and motivational seminars. How do the rich people make their money work for them? They do so by investing in viable businesses. If the rich become rich by investing in businesses, how do they differentiate between viable businesses and the struggling firms? The answer is simple. They or their financial advisors conduct financial performance analysis using horizontal analysis, vertical analysis, and ratio analysis.
Asset managers and retail investors apply ratio analysis to a firm before investing in that firm. The ratio analysis provides insight into the financial health of the business. Buying some shares in a company in a financial coma is similar to throwing away your resources. The health status of the business must be assessed prior to committing capital.
Analysts focus on ratios such as profitability ratios, liquidity ratios, efficiency ratios, solvency ratios, and gearing ratios. These ratios are expressed as percentages. The gross profit margin is a profitability ratio that compares gross profit to the total revenue. A business is considered profitable if its gross profit margin is 50% and above. This is often applied to businesses like retail businesses, restaurants, etc.
The liquidity ratios reveal a company’s ability to satisfy its short-term financial obligations. An example is the current ratio which compares the current assets of the company to its current liabilities. A ratio of 1:1 or 100% shows that for every $1 a company owes, he has another $1 to pay for it. This implies that the company is liquid. A company with a current ratio greater than 100% is considered liquid.
The efficiency ratios assess if the company uses its assets to generate revenue optimally. An example is the fixed asset turnover which compares net sales to an average fixed asset. This ratio is industry-dependent and the benchmark varies across different industries. This ratio is more useful for companies who invest heavily in fixed assets e.g., Caterpillar or Toyota. The metric means little to technology firms like Meta (Facebook).
The debt-to-equity ratio is a gearing ratio that evaluates a firm’s ability to meet its debt obligations. A D/E ratio greater than 100% implies that the firm utilizes more debt financing than equity financing. There is no prescriptive target D/E ratio but investors are mindful of excessive debt levels compared to shareholders’ funds.
Investment ratios like earnings per share express a firm’s revenue per unit of shares outstanding. This metric is applied frequently by equity investors in assessing investment options. Dividend per share is related to this and it reveals the amount of dividends each share is entitled to.
The foregoing financial ratios are adopted frequently by investors and creditors alike. The ratios reveal significant information about a firm but they should be considered in addition to qualitative factors. These factors include management pedigree, market share, and economic realities. A robust combination of quantitative and qualitative provides adequate insight into a company under consideration.