It is important to make wise investments and selecting the right stock can be profitable.
It is important to make wise investments and selecting the right stock can be profitable. There are many different metrics an analyst can look at to help determine the likely profitability of a stock. Profitability ratios, liquidity ratios, debt utilization ratios, and looking at trend analysis can help guide an analyst to selecting a profitable stock. The profitability ratios measure the ability of a firm to earn a good return on sales, total assets, and invested capital (Block et al., 2019). The liquidity ratios are the firm’s ability to pay off short-term obligations when they are due (Block et al., 2019). The debt utilization ratios look at the debt position and evaluate it from the firm’s asset base and earning power (Block et al., 2019). The trend analysis lets you look at the performance over the years and it is important to compare it to the industry. The profitability, liquidity, and debt utilization are important to analysts or investors to see the amount of profitability and the likelihood of the firm to be able to pay off debt. Looking at the trend analysis will help you see how the company is doing over time compared to the competitors in the industry.
The ratios that I would use to assess the profitability of a firm would the profit margin, return on assets, and return on equity ratios. The profit margin is net income divided by sales. The return on assets is net income divided by total assets. Return on equity is net income divided by stockholder’s equity (Block et al., 2019). These ratios provide the profitability of the company and a company with higher profits has a better chance of a higher return on the stock.
The ratios that I would use to determine the liquidity would be the current ratio and quick ratio. The current ratio is current assets divided by current liabilities. The quick ratio is (current assets – inventory) divided by current liabilities. These ratios show the firm\’s ability to pay off debt as it is due, and a higher ratio compared to the industry should show the firm is able to better pay down debt compared to their competitors (Block et al., 2019).
The debt utilization ratios that I would use are debt to total assets, times interest earned and fixed charge coverage. Debt to total assets is total debt divided by total assets. Times interest earned is income before interest and taxes divided by interest. Fixed-charge coverage is income before fixed charges and taxes divided by fixed charges. These ratios will help you measure and understand the firm’s debt management policies (Block et al., 2019). The acceptable range is typically under 50% in debt to total assets.
The reason why I would choose all these ratios to analyze before making an informed decision on the purchase of stock is that I would mostly want to know company profitability and their ability to pay off and manage debt. It is important for a company to be profitable because this is a good indicator that the stock will rise. It is also important to be able to pay off and manage debt to have less liability. It is also important to compare these ratios to the competition in the industry to know where the company stands. Some ratios may seem to be increasing or decrease within the organization but compared to the industry the decreases may still be ahead of the competition and the increases could be below the competition. Therefore, it is important to compare the company number to the industry. Comparing trend analysis against the industry is also important and can give insight on future trends of the company\’s performance compared to the industry. When selecting stock it is important to prioritize profitability ratios then liquidity and debt utilization against the industry to identify strong firms to invest in.
References
Block, S. B., Hirt, G. A., & Danielson, B. R. (2019). Foundations of financial management (17th ed.). Retrieved from https://www.vitalsource.com/
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