• Asset Turnover
  • Average Collection Period
  • Average Days in Inventory
  • Beta
  • Current Ratio and Acid Test
  • Debt/Equity
  • Earnings Per Share
  • EBIT and EBITDA
  • Gross Profit Ratio
  • Inventory Turnover Ratio
  • Operating Margin
  • Price/Book
  • Price/Sales
  • Price-Earnings Ratio
  • Profit Margin
  • Receivables turnover ratio
  • Return on Assets
  • Return on Equity
  • Times Interest Earned Ratio

      2 things, 1.... I know all the ratios above look intimidating, but I promise learning them is not that bad and I explain that all below, and 2.... This page includes a lot of reading (Sorry) there is really no way around it. Learning all the metrics and ratios used to evaluate a business is essential for investment bankers and analysts to forecast future growth. The most important part here is understanding how the metrics and ratios are applied and what they affect. If you only know the definitions you are no better than AI, you have to be able to apply them.

I will provide all the definitions below, but the most important part is the paragraph and video at the bottom explaining how to use them. Any website can have a definition, I will teach you how to use these metrics, anyone can memorize a formula.

It is also important to look at KPIs (mentioned below) and look at all of these metrics in unison and not just looking at one or two. Let's get this out of the way now, a lot of people talk so highly of the P/E ratio but if you just look at that it could be a horrible turn off for a company. We will see how to evaluate a company USING ALL these metrics in a video down below. Not saying the ratio is bad, just saying look at everything else too.

Finally, it is important to compare metrics of companies in the same industry, as different industries have different standards as you will learn. Therefore, comparing Apple's ROA to John Deere's does not provide a good representation of either company.

Solvency and Liquidity

Let's start with 8 key Solvency and Liquidity rations. Solvency refers to a company's ability to pay all of its liabilities, including long term, while Liquidity is the ability to pay only current labilities (within 1 year).

Now let's learn how to use some of these when evaluating a company. Starting with the 

Inventory turnover ratio - This measures how many times, on average, a company sells its entire inventory during the year. A high inventory turnover ratio usually is a positive sign. It indicates that inventory is selling quickly, less cash is tied up in inventory, and the risk of outdated inventory is lower. However, an extremely high inventory turnover ratio might be a signal that the company is losing sales due to inventory shortages. 

Directly related to that is the Average Days in Inventory - converting the inventory turnover ratio into days gives you the average days in inventory. As you can imagine, companies try to minimize the number of days they hold inventory. 

These ratios vary significantly by industry. Ex. compared with the sporting goods apparel industry, the dairy industry with perishable products has a much higher inventory turnover, and car dealerships have a lower inventory turnover. Inventory turnover might even vary by product within the same industry. For instance, within the dairy industry, the inventory turnover for milk is much higher than that for aged cheddar cheese. Similarly, within the auto industry, the inventory turnover for cars like the Chevy Impala is much higher than for the higher-priced Chevy Corvette.

Next up is the Current ratio and acid test (Quick Ratio). Both measure how well a company can cover its current liabilities. If you look at the equation you can see you want a number that is 1 or above, meaning they have enough assets to cover the liabilities.

However, a high current ratio is not always a good signal. A high current ratio might occur when a company has difficulty collecting receivables or carries too much inventory. Analysts become concerned if a company reports an increasing current ratio combined with either a lower receivables turnover ratio or a lower inventory turnover ratio. 

The acid-test ratio is similar to the current ratio but is a more conservative measure of current assets available to pay current liabilities. Specifically, the top part of the fraction includes only cash, current investments, and accounts receivable. Because it eliminates current assets such as inventories and prepaid expenses that are less readily convertible into cash, the acid-test ratio often provides a better indication of a company’s liquidity than does the current ratio.

Lastly, for this section, we will hit the Debt/Equity ratio. Because total (current and long-term) liabilities are in the numerator, the higher this number, the more likely a company is to go bankrupt. This metric is also industry specific, as some industries such as airlines need to take on a lot more debt to purchase more capital, such as planes and machinery. Whereas energy companies like Frontdoor inc. (Cloud Computing company) might have a lower D/E because there is not as much equipment and major financing involved. 

It is important to look at industry averages for all of these metrics, because a high D/E might not be a bad thing if cash flow and returns are high enough to pay off the debt and the company needs the debt to grow.

Profitability ratios

These ratios all focus on the profitability, earnings, and operating efficiency of a company. Not only is profitability needed for company success, but these are also the ratios used by analysts and investors to help them pick stocks.

Return on Assets (ROA) - VERY important metric no matter the industry, this measures the income the company earns on each dollar invested in assets. The higher the number the more efficient a company is at turning an investment into income. Put simply, a higher ROA means more asset efficiency. (expressed as %)

Profit Margin - Measures the income earned on each dollar of sales. If a company has a profit margin of 6.0%, then for every dollar of sales, 6 cents will go towards net income. Maintaining a Profit margin at or above industry level and increasing over time can show a company achieving lower COGS, and becoming more efficient, thus more profitable. 

Return on Equity (ROE) - Measures the income earned for each dollar in stockholders’ equity. Return on equity relates net income to the investment made by owners of the business. ROE is a gauge of a corporation's profitability and how efficiently it generates those profits. The higher the ROE, the better a company is at converting its equity financing into profits.

Earnings Per Share (EPS) - The higher the EPS, the more profitable a company is. The EPS shows how much money a company makes for each share of its stock.

Price-earnings ratio (P/E) - Tells you whether the price accurately reflects the company’s earnings potential, or its value over time. The higher the ratio, the more expensive a stock is relative to its earnings. The lower the ratio, the less expensive the stock. However, a high P/E is not directly correlated to a bad stock, as most growth stocks have high P/E ratios. The S&P 500 average P/E is about 17 and Amazon currently has a P/E of 60 and Amazon is a great company, it is just growing very fast. 

If you use the P/E ratio, also use the forward P/E, which uses forecasted earnings for the next year instead of current EPS. So, you want a lower forward P/E than current P/E because this means the earnings will be higher. More mature companies may have a very stable P/E, so this is more of a growth stock indicator. 

Other Metrics

Beta - A measure of a stock's volatility relative to the S&P 500. The 500 Index has a beta of 1 and a beta higher than 1 means a stock is more volatile than the market and vice versa, less than 1 means less volatile than the market. A beta of 2 means this stock goes up 2% when then market goes up 1%.

EBIT - Earnings before Interest and taxes. Used to measure a company's core business profits without the taxes and interest.

EBITDA - Earnings before Interest, taxes, Depreciation, and amortization. Can be used to track company performance without taking into consideration their depreciation of assets and finance decisions.

Price/Sales (P/S) - Compare how much an investor is willing to pay for a stock compared to the company's revenue. Calculated by taking Share price / Revenue Per Share trailing 12 months (TTM). Used to compare companies to other companies, an industry, or the whole market. PS < 1 = Strong share price performance and    PS > 1 = Stock is Expensive. 

Price/Book (P/B) - Compares a stock's current price to the net worth of the company's assets. Book value is how much a company is worth if they sold all of their assets (Tangible) and paid off all of their liabilities. Stock price / BV per share. BV = (assets - Liabilities) / Shares outstanding which gives a multiple and lower the multiple the better (2 can be good and 10 is generally worse for example). 

Operating Margin - % of revenue left after companies pay certain variable costs (wages, materials, etc.) Operating Income / Net Sales, meaning the higher the margin the better and you want to see increase over time. This metric (like all the others) should be used to compare similar companies in the same industry.

Every investor needs to not only know these metrics, but also be able to use them and apply them to the market. This involves using multiple metrics in unison to help evaluate a company as a whole and against its peers.

Click the video ⬇️