This blog will look at several key financial terms for analyzing investments rather than two stocks, as we typically do.
A current ratio is a financial metric that measures the ability of a company to pay off short-term obligations (typically a year). From the perspective of investors and analysts, the current ratio parallels a company’s risk in that a higher ratio implies less riskiness. Current ratios should typically be around the same or higher than their industry average, normally 1.00. Short-term obligations can be paid down using certain entities such as cash, liquidating inventory, and factoring receivables. Over time, the current ratio can vary.
A quick ratio is a liquidity ratio that measures a company’s ability to pay off short-term obligations using only quick assets. If a quick ratio is above 1.0, a company can pay off its responsibilities instantly by liquidating assets if needed. In contrast, higher values suggest that the company is not using its assets effectively. On the other hand, a quick ratio below 1.0 means that the company simply does not have enough quick assets to cover its needs.
The Days in AR metric measures the average number of days it takes to collect a payment. Typically, companies don’t want to have a value much longer than two months because it will tell investors that the company is inefficient in its dealings with clients. On the other hand, a short value for this ratio demonstrates that the company works efficiently with all clients and that they are not particularly volatile.
A gross margin measures a company’s sales revenue after accounting for various direct costs. Typically, a higher gross margin means that a company is making more capital which can be used for other purposes such as paying off debt.
An operating margin measures how much profit a company makes on a dollar of sales after paying for production costs. Viable companies typically have a very high operating margin to demonstrate that their daily, weekly, monthly, and yearly operations are run smoothly, efficiently, and profitably.
Return on assets measures a company’s earnings before taxes and interests related to its total net assets. Companies with higher return on asset values demonstrate to potential investors that their operations are very efficient and organized.
Return on equity measures a corporation’s profitability in relation to stockholder’s equity. This metric is one of the most vital for investors to analyze: a very high return on equity means that a company can increase its profit generation without needing as much capital to fund its needs and operations.
Free cash flow represents how much cash a company generates after cash outflows to maintain its fixed and capital assets. A company should aim for a positive free cash flow. This metric can also serve as an overall glance at arising fundamental problems. A consistently negative free cash flow balance can signal a going concern.