This is Andrew Horowitz with The Winning Investor's Quick and Dirty Tips for Beating the Market and I'm here to help you turn simple financial ratios into smarter investment decisions.
Financial Ratios
So what is a company ratio and how can it help me?
When investors study a company, they often look at different financial ratios to see if they can figure out new trends of growth or see if a company might be struggling in some way. They are trying to study the company's past financial statements to get a feel for a company's attractiveness through looking at certain concrete facts: a company's financial health, its competitive position, how it uses its money, what kind of investment return the company gets, and finally how profitable a company might be relative to peers.
Assets to Liabilities: The Simplest of All Ratios
Ratios divide one thing by another. The easiest ratio to study - and one of the best indicators of a company's success and competitive edge - would be a ratio that divides the company's assets by their liabilities. Going back to Economics 101 here, an Asset is something that a company owns that has value, like land, inventory, equipment, products, accounts receivable, stocks, and bonds. Some companies have intangible assets that give them a competitive advantage but are difficult to put an exact price on, like trademarks, patents, and copyrights. On the other hand, a Liability refers to the debt a company has. Liabilities include obligations a company owes to other companies or shareholders, like loans, accounts payable, company bonds they have sold, and other assorted debts. Liabilities aren't necessarily bad -- after all, it takes money to make money!
So, the Assets to Liabilities ratio is usually the first thing an investor wants to know. It can quickly tell you if a company might be in financial trouble, and will also indicate which companies might be better positioned to weather difficult financial storms.
Divide reported Assets by reported Liabilities. A ratio of one means that a company’s assets and liabilities are equal. If the ratio is less than one, it’s considered a low ratio. A low ratio might mean that a company is in trouble and might not be able to meet its obligations in a difficult environment. A ratio greater than one is considered a high ratio and means a company has more assets than liabilities, which could mean they're more attractive than a company with a lower ratio. A company’s high ratio may indicate that a company is in a good position to survive hardship because of all its valuable assets and so it might be a better investment than a company with a lower ratio. A reading that is too low might mean that a company is in trouble and might not be able to meet its obligations in a difficult environment.
But here’s where it gets confusing: a low ratio doesn’t always indicate a company is in trouble, and a high ratio doesn’t necessarily mean a company is safe from trouble. So what’s the point, you ask? I’ll tell you.
Ratios Help You Compare Companies
Why should you care about comparing ratios and doing more math if it doesn't give you absolute answers? If you know about company ratios, you can compare different companies to each other using apples to apples comparisons. This can therefore help you make better investment decisions. All companies have revenue, assets, liabilities, debt and other components you can use to figure out ratios that will allow you to see if they're doing better or worse than their competitors or other companies in a different industry. You can also use these ratios to see which companies are more prepared to adjust in a changing economic environment, which would have been helpful to know in 2008!
