Street signs of the balance sheet of a company are financial ratios. Turn a blind eye to them and you are driving blindly. Look at them and you are at least aware of the direction taken by the road. The liquidity ratios inform you whether a business is free to stop sweating when paying its bills. The current ratio is crude and handy. Is this company able to capitalize on short term commitments or is it walking on knives? The quick ratio is harsher. Inventory is kicked out of the room. Cash and near-cash come up. Where such figures appear to be weak, alarm bells should sound. Not sirens. More as though that queasy feeling before something goes wrong.
The conversation is changed by profitability ratios. Margins reveal the amount of money left after the dust settled down. Gross margin discusses the pricing power and cost control. Operation margin shows discipline or havoc within the business. The last report card is the net margin. There are companies that make sales and retain minimal sales. Others make fewer sales and smile on their way to the bank. Return on equity is a thief in many occasions. It answers a simple question. When I place my money in this company what do I receive in return? High numbers excite people. Sometimes too much. Leverage can juice returns. It can also blow them up.
The leverage ratios should be respected. Debt appears to be angst when the times are good. The interest coverage indicates that earnings are not choked by interest payments. A low on this is a red flag on teeth. The explanation of why the management is aggressive is the debt to equity. There are industries that exist at high debt levels. Utilities get a pass. Tech startups don’t. Context matters. Always. At some point, I could see a friend purchasing stock simply because revenues were increasing at a high rate. He omitted the leverage ratios. The firm went bankrupt on its debts. Lesson learned. Pain is a strict teacher.
Efficiency ratios speak less, and tell more. Inventory turnover indicates the flow or accumulating of products. Turnover of the receivables gives a clue on the speed of payment by the customers. Late collections put cash flow under strain. Cash flow rarely lies. The question that is posed by asset turnover is how hard assets are toiling. Two firms might have vastly different portfolios and make the same profit. One sweats its machinery. The other lets it nap. Which one do you guess accommodates more to trouble when it appears. Ratios such as these do not scream. They come up to you and tap you on the shoulder.
The most controversial ratios are the valuation ratios. The price-to-earnings are notorious and commonly exploited. Both high P/E can imply optimism or insanity. Decay or value may be indicated by Low P/E. Until price-to-book matters, it is ignored. Price-to-sales comes in when the profits disappear. There is no such thing as a truth value in one ratio. They argue with each other. That’s healthy. Financial ratios, rather than being solo, are better as chorus. Read them together. Compare them over time. Stack them against peers. Numbers are not random forecasts of the future, however, they provide hints. And hints, even at their most favourable, are as nothing in comparison to the gut feelings.