Profitability And Solvency

As boring or burdensome as the subject sounds, financial ratios are really the ‘meat’ of analyzing stocks. But, many investors do not use their attentiveness when it comes to doing some relatively simple things to make sure that the industry they are investing in is a well position for their had earned investment dollars. A solid company does not need to go through all these ratio tests, but at least, it should pass the ones regarding solvency and profitability.

Profitability: Observe the following questions properly.

• Is the company making the money?
• Is it making less or more than it did in the prior period?
• Are sales rising?
• Are profits rising?

You need to answer the above questions by observing the following ratios:

• Equity return
• Common Size Ratio
• Return on Assets

Solvency: Observe the following questions properly.

• Is the company maintaining debts and other liabilities under control?
• Are the company’s assets rising?
• Is the company’s total equity rising?

You need to answer the above questions by observing the following ratios:

• working Capital
• Quick Ratio
• Debt to Net Equity

While you observing the ratios, keep the following points in mind:

• Every company and/or industry never the same. A ratio that looks difficult or problematic in one company may be just well in another. You must investigate it.
• One ratio is not enough for investment decision. So try to look at several ratios which will help to cover the major aspects of a company’s finances.
• You need to see at 2 or more years of a company’s numbers to find out whether the most recent ratio is good, bad or worse or unchanged from the prior year’s ratio. Ratios will help you regarding the company’s prospects.

Liquidity Ratios: It means the ability to rapidly turn assets into cash. Liquid assets are simply assets that are easy to transfer to cash. e.g. Real Estate, is surely an asset. But it is not liquid asset because transferring it to cash could take much time (weeks, months or even years).

Current assets such as savings account, checking accounts, accounts available, marketable securities and inventory are easy to sell or transfer to cash in a very small period of time. Bill paying or urgent debt takes liquidity. Liquidity ratios will help you to understand a company’s capacity to pay its current liabilities. The quick ratio and current ratio are the most common liquidity ratios.

Operating Ratios: It basically measures the efficiency of company. “How is the company running its sources?” is a question normally answered with operating ratios.

Solvency Ratios: It means that the company is not overwhelmed by its liabilities. Insolvency means ‘Oops! Too late.’ Solvency ratios consider the relationship between what the company owns and what it owes.