Trading Up-Close: Measures of Financial Strength


Before buying stock in a company, you want
to get a sense of whether it might have the financial strength to stay in business for
the long-term. A company that can turn a profit, has the
cash to pay for its operations and isn’t deeply in debt is usually a better investment
than a company that’s struggling. To understand a company’s financial health,
you can start with three measures: profitability, liquidity and solvency. Let’s start with profitability. Profits are the lifeblood of any company,
helping them secure credit, expand operations, and attract investors. If you’re a shareholder, you want to make
sure the company is efficiently turning revenue into profits—which can then be converted
into dividends or reinvested in the company to drive future growth. One way to measure profitability is to look
at the profit margin. You calculate this by dividing the company’s
profits by its sales. For example, if a company generates $20 million
in profits on $100 million in sales, it has a profit margin of 20%. Generally, the higher the number, the better. Next, liquidity measures a company’s ability
to cover its expenses on a day-to-day basis. Two common ways to determine liquidity are
the current ratio and quick ratio. The current ratio divides current assets such
as cash, marketable securities, accounts receivables, prepaid expenses, and inventories by current
liabilities. These include accounts payable, accrued payables,
and short-term payables. Generally, the higher the current ratio, the
better. Current ratios do vary by industry, so check
the industry average before making any investment decisions. The quick ratio is similar, but it does exclude
inventories from the calculation. Why? Because inventories are often the least liquid
of the current assets, so excluding them gives you a more conservative estimate of how well
a company is positioned to handle its short-term expenses. Finally, solvency is related to liquidity,
but instead of looking at short-term expenses, it measures a company’s long-term ability
to pay its debt. One common measure is the debt-equity ratio,
or the leverage ratio. This measures the percentage of the company’s
total debt relative to its shareholders’ equity. It’s very similar to a homeowner’s mortgage
compared to their equity in the house. Lower is generally better, as it signals more
of the company’s operations are financed by equity than by debt. That’s important because shareholders don’t
charge the company interest, but bondholders do. A reasonable rule of thumb is to look for
companies with a debt-equity ratio of less than 50%. You can use profitability, liquidity, and
solvency measures to screen for companies with good profit growth, healthy margins,
and strong balance sheets. To learn more about the tools you can learn
in your trading, watch the other videos in this series and subscribe to our YouTube channel.

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