Ratios can be invaluable tools for making investment decisions. Even so, many new investors would rather leave their decisions to fate than try to deal with the intimidation of financial ratios. The truth is that ratios aren't that intimidating, even if you don't have a degree in business or finance. Using ratios to make informed decisions about an investment makes a lot of sense, once you know how.
There are a large variety of ratios out there, but financial ratios can be broken up into four major categories: profitability ratios, liquidity ratios, solvency ratios and valuation ratios. In this article, we'll take a look at each of the four categories and provide an example of a simple-to-use ratio for each of them.
Profitability is a key piece of information that should be analyzed when you're considering investing in a company. This is because high revenues alone don't necessarily translate into dividends for investors (or increased stock prices, for that matter) unless a company is able to clear all of its expenses and costs.
Liquidity is a measure of how quickly a company's assets can be converted to cash. Liquidity ratios can give investors an idea of how capable a company will be at raising cash to purchase additional assets or to repay creditors quickly, either in an emergency situation, or in the course of normal business.
Solvency ratios are used by investors to get a picture of how well a company can deal with its long-term financial obligations and develop future assets. As you might expect, a company weighed down with debt is probably a less favorable investment than one with a minimal amount of debt on its books.
Valuation ratios are used to analyze the attractiveness of an investment in a company. The idea is that by using these ratios, investors can gain an understanding of how cheap or expensive a company's current stock price is, compared to several different measures. In general, the less expensive a company is, the more attractive an investment in that company becomes.
Source : Investopedia