Fundamental Analysis Tools
One of the biggest challenges that any investor has is trying to decide on a company to buy. Though we might wish to buy as many stocks as we want, we are limited by the amount of money we have. As such, we have to find fundamental analysis tools that will make the choice easier and more informed.
Having gone through financial statements like balance sheets, income statements and profit and loss statements and are satisfied with a number of companies, we need to come up with a way to compare them. For this, we use financial ratios.
Financial ratios are used to compare the risk and return of different firms to make intelligent investment decisions. Such decisions range from evaluating changes in performance over time to a comparison among all firms within a single industry at a point in time. Financial ratios are grouped into four categories:
1. Activity Analysis Ratios
Activity analysis ratios evaluate the revenue and output generated by the firm’s assets. They are used to describe the relationship between the firm’s sales and the assets needed to sustain the sales. The higher the ratio the more efficient the firm’s operations as relatively fewer assets are required to maintain a given level of sales.
These ratios include Inventory turnover, receivables turnover, average number of days inventory in stock, working capital turnover and payables turnover.
2. Liquidity Analysis Ratios
Liquidity analysis ratios are used to measure the adequacy of a firm’s cash resources to meet its near term cash obligations. You do not wish to invest in a firm that is not able to pay its short-term debt as it may become insolvent very quickly.
Ratios commonly used in liquidity analysis include the quick ratio, cash ratio, and the current ratio.
3. Long-Term Debt Ratios
You also need to invest in a company, which can afford its long-term debt. This is a great indicator of the viability of a company in the long term. A company with a rate of return higher on assets financed by long-term debt, which has a lower cost, will likely continue giving excess returns.
Ratios used for this analysis include debt to equity ratio, debt to total capital ratio and the capital expenditure ratio.
4. Profitability Ratios
Your main concern is to invest in a company that is profitable and ahs the ability to generate, sustain and grow the profits. The more profitable a firm is, the higher the stock price and more likely it will sustain bad periods.
Such ratios include return on income, return on assets, gross margin, and return on total capital.
5. Valuation Ratios
Investors use valuation ratios more than any other ratios to make investment decisions. These ratios are used as the basic fundamental analysis tools and include the price to book ratio, dividend yield, price to earnings ratio, price to sales ratio and the earnings per share ratio.
The proper use of ratios by any investor will require serious study and interpretation. However, any stock investor worth his salt should take the time to learn them and in time will make better stock investment decisions.
