Appendix B. Financial Ratios

Considering how many financial catastrophes have occurred in recent years (and continue to occur in the current headlines), doing your homework regarding the financial health of your stock choices is more important than ever. This Appendix should be your go-to section when you find stocks that you're considering for your portfolio. It lists the most common ratios that investors should be aware of and use. A solid company doesn't have to pass all these ratio tests with flying colors, but at a minimum, it should comfortably pass the ones regarding profitability and solvency:

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

    You can answer these questions by looking at the following ratios:

    • Return on equity

    • Return on assets

    • Common size ratio (income statement)

  • Solvency: Is the company keeping debts and other liabilities under control? Are the company's assets growing? Is the company's net equity (or net worth or stockholders' equity) growing?

    You can answer these questions by looking at the following ratios:

    • Quick ratio

    • Debt to net equity

    • Working capital

Note

While you examine ratios, keep these points in mind:

  • Not every company and/or industry is the same. A ratio that seems dubious in one industry may be just fine in another. Investigate and check out the norms in that particular industry. (See Chapter 13 for details on analyzing industries.)

  • A single ratio isn't enough on ...

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