Asset Turnover
The Asset Turnover ratio assesses how efficiently a company uses its assets.
This ratio is obtained by dividing a company's sales by its assets.
A high asset turnover ratio signals that a company uses its assets efficiently to generate sales. On the other hand, a low asset turnover ratio signals that a company needs to make the most efficient use of its assets.
For example, let's take two companies, A and B.
Both companies generate $100,000 in yearly sales. Let's assume that company A has $25,000 worth of assets while company B has $50,000 worth of assets.
This means that the Asset Turnover ratio of company A is four while the Asset Turnover ratio of company B is 2.
If all other things are equal, we can conclude that company A is utilizing its assets better than company B.
This ratio is obtained by dividing a company's sales by its assets.
A high asset turnover ratio signals that a company uses its assets efficiently to generate sales. On the other hand, a low asset turnover ratio signals that a company needs to make the most efficient use of its assets.
For example, let's take two companies, A and B.
Both companies generate $100,000 in yearly sales. Let's assume that company A has $25,000 worth of assets while company B has $50,000 worth of assets.
This means that the Asset Turnover ratio of company A is four while the Asset Turnover ratio of company B is 2.
If all other things are equal, we can conclude that company A is utilizing its assets better than company B.
Debt to Equity
The debt-to-equity indicates how much leverage a company is using.
More specifically, a company has resources it owns (assets) and obligations (liabilities). Those obligations can be toward creditors (debt) or shareholders (equity).
The debt-to-equity ratio allows us to identify which proportion of the liabilities are towards third parties and which proportion is towards shareholders.
The formula is "debt divided by equity". Therefore, a high debt-to-equity ratio implies that the company is funded mainly through debt. High debt relative to equity signals higher risk because the company is obliged to service its debt. In other words, the company must pay installments and eventually reimburse the principal.
A high and growing debt-to-equity ratio can indicate that a company has difficulty generating enough cash to service its debt.
On the other hand, a small debt-to-equity ratio shows that a company is funded mainly through equity, which is a sign of financial stability.
More specifically, a company has resources it owns (assets) and obligations (liabilities). Those obligations can be toward creditors (debt) or shareholders (equity).
The debt-to-equity ratio allows us to identify which proportion of the liabilities are towards third parties and which proportion is towards shareholders.
The formula is "debt divided by equity". Therefore, a high debt-to-equity ratio implies that the company is funded mainly through debt. High debt relative to equity signals higher risk because the company is obliged to service its debt. In other words, the company must pay installments and eventually reimburse the principal.
A high and growing debt-to-equity ratio can indicate that a company has difficulty generating enough cash to service its debt.
On the other hand, a small debt-to-equity ratio shows that a company is funded mainly through equity, which is a sign of financial stability.
EBIT
The Earnings Before Interest and Taxes (EBIT) is the company's profit before deducting taxes and interest expenses.
EBIT can also be called operating income, operating earnings, or operating profits. It is an important indicator as it allows us to compare companies' performance with different tax situations.
The same reasoning applies to the debt structure. For example, a highly leveraged company might have a lower net income but higher EBIT than its competitor. Assuming similar revenues, this would mean that the company would be performing better than its competitor despite having a lower bottom line.
We calculate the EBIT by following the formula: EBIT = Revenues - COGS - OPEX.
OPEX is the Operating Expenses, and COGS is the Cost of Goods Sold which can also be called the Cost of Revenues.
EBIT can also be called operating income, operating earnings, or operating profits. It is an important indicator as it allows us to compare companies' performance with different tax situations.
The same reasoning applies to the debt structure. For example, a highly leveraged company might have a lower net income but higher EBIT than its competitor. Assuming similar revenues, this would mean that the company would be performing better than its competitor despite having a lower bottom line.
We calculate the EBIT by following the formula: EBIT = Revenues - COGS - OPEX.
OPEX is the Operating Expenses, and COGS is the Cost of Goods Sold which can also be called the Cost of Revenues.
The model is conceptually simple. The tricky part is to compare the companies efficiently.
Free Cash Flow
The Free Cash Flow is the cash generated by the company from its normal operations.
This indicator is crucial as it shows the cash remaining after the company made its investments (usually referred as CAPEX, short for Capital Expenditure) but before the company paid its creditors and shareholders (dividends).
Given that this cash is available after investments but before dividends and shares repurchases. As a result, it is an essential indicator of a company's ability to pay back its debt and distribute dividends.
An increase in the company's Free Cash Flow is a positive indicator. This can imply that the company can safely increase its dividend distribution which in turn increases the stock price while rewarding existing investors with immediate cash.
This indicator is crucial as it shows the cash remaining after the company made its investments (usually referred as CAPEX, short for Capital Expenditure) but before the company paid its creditors and shareholders (dividends).
Given that this cash is available after investments but before dividends and shares repurchases. As a result, it is an essential indicator of a company's ability to pay back its debt and distribute dividends.
An increase in the company's Free Cash Flow is a positive indicator. This can imply that the company can safely increase its dividend distribution which in turn increases the stock price while rewarding existing investors with immediate cash.
Gross Margin Growth (YoY)
The Gross Margin is the Sales after deducting the associated direct costs.
The formula is: Gross Margin = Sales - COGS. This can also be written: Gross Margin = Revenues - Cost of Revenues.
Revenues allow us to identify how many market shares a company has. However, a company might increase its revenues by slashing its prices. Conversely, another company might have smaller revenues but better performance.
To know the actual income available to the company, we must look at the Gross Margin.
The Gross Margin Growth indicates how the Gross Margin is evolving from one year to the other. A positive trend suggests that the company successfully optimized the cost to generate revenues or its revenues, or both.
The formula is: Gross Margin = Sales - COGS. This can also be written: Gross Margin = Revenues - Cost of Revenues.
Revenues allow us to identify how many market shares a company has. However, a company might increase its revenues by slashing its prices. Conversely, another company might have smaller revenues but better performance.
To know the actual income available to the company, we must look at the Gross Margin.
The Gross Margin Growth indicates how the Gross Margin is evolving from one year to the other. A positive trend suggests that the company successfully optimized the cost to generate revenues or its revenues, or both.
Payout Ratio
The Payout Ratio indicates which portion of the company's profits are distributed as dividends to its shareholder.
The Payout Ratio can also be called the Dividends Payout Ratio. This indicator is important to understand whether the current dividends are sustainable. Indeed, what is distributed is not re-invested. Should the Payout Ratio exceeds 100% (more than its profits), one can wonder how the company will sustain it.
A high Payout Ratio is not ideal as it might indicate a lack of vision for future growth. On the other hand, a low or inconsistent Payout Ratio is also a source of concern as there is a higher uncertainty on future dividends.
In this case, consistency is preferable and a positive, and consistent Payout Ratio is even better.
The Payout Ratio can also be called the Dividends Payout Ratio. This indicator is important to understand whether the current dividends are sustainable. Indeed, what is distributed is not re-invested. Should the Payout Ratio exceeds 100% (more than its profits), one can wonder how the company will sustain it.
A high Payout Ratio is not ideal as it might indicate a lack of vision for future growth. On the other hand, a low or inconsistent Payout Ratio is also a source of concern as there is a higher uncertainty on future dividends.
In this case, consistency is preferable and a positive, and consistent Payout Ratio is even better.
Revenue Growth (YoY)
This ratio indicates how the Revenues, also called Sales, evolve from one year to the other.
All things being equal, the higher the Revenue Growth, the better.
All things being equal, the higher the Revenue Growth, the better.
Return on Assets (ROA)
The Return on Assets is one of the most important ratios as it shows how efficiently the company generates profits from its resources.
The formula is the net income divided by the sum of all the company's assets.
People usually consider the ROA is an excellent indicator of management effectiveness.
Due to the variations of assets in each industry, it is essential to compare the ROA of similar industries to gain insight from this ratio.
The formula is the net income divided by the sum of all the company's assets.
People usually consider the ROA is an excellent indicator of management effectiveness.
Due to the variations of assets in each industry, it is essential to compare the ROA of similar industries to gain insight from this ratio.
Return on Equity (ROE)
The Return on Equity is also one of the most important ratios, showing how efficiently the company generates profits without debt.
The formula is the net income divided by the equity of the company.
Assuming there was no debt whatsoever, the ROE would equal the ROA. However, this is rarely the case, and leverage is helpful to maximize the investments' performance. Hence, the need to take the ROE into account.
The ROE measures profitability and helps understand how the company will generate value for its investors.
The formula is the net income divided by the equity of the company.
Assuming there was no debt whatsoever, the ROE would equal the ROA. However, this is rarely the case, and leverage is helpful to maximize the investments' performance. Hence, the need to take the ROE into account.
The ROE measures profitability and helps understand how the company will generate value for its investors.
Stock purchase to Net Income
This ratio indicates how much of a company's profits are used to repurchase its shares.
Assuming a company has cash and believes its shares are undervalued, it would make sense to repurchase them from the market.
This, in turn, reduces the number of outstanding available shares and assuming an equal demand, the price per share will increase.
Because of that, it might also be used as a tactic by the company to improve its ratios artificially. For example, fewer shares also mean an increase in the EPS (Earnings per share). Similarly, less equity will lead to an increase in the ROE.
Assuming a company has cash and believes its shares are undervalued, it would make sense to repurchase them from the market.
This, in turn, reduces the number of outstanding available shares and assuming an equal demand, the price per share will increase.
Because of that, it might also be used as a tactic by the company to improve its ratios artificially. For example, fewer shares also mean an increase in the EPS (Earnings per share). Similarly, less equity will lead to an increase in the ROE.
Working Capital Turnover
This indicator tells us how effectively the company is generating sales from its working capital.
The working capital, also called current working capital, is the difference between the current assets and the current liabilities.
In other words, this reflects whether the company has enough resources to cover its short-term obligations. As a result, a negative working capital is an indicator of low liquidity and possible default issues.
To calculate the Working Capital Turnover, we divide the Revenues by the average working capital.
The higher this ratio, the more the company can use its short-term net resources to generate sales. On the other hand, a low ratio can signal that the working capital is too high, for example, because of excessive inventory or bad receivables.
Therefore, the Working Capital Turnover indicates a company's efficiency.
The working capital, also called current working capital, is the difference between the current assets and the current liabilities.
In other words, this reflects whether the company has enough resources to cover its short-term obligations. As a result, a negative working capital is an indicator of low liquidity and possible default issues.
To calculate the Working Capital Turnover, we divide the Revenues by the average working capital.
The higher this ratio, the more the company can use its short-term net resources to generate sales. On the other hand, a low ratio can signal that the working capital is too high, for example, because of excessive inventory or bad receivables.
Therefore, the Working Capital Turnover indicates a company's efficiency.
Altman Z-score
The Altman-Z-Score is a credit strength test.
This score was developed in 1967 by Professor Edward Altman and has displayed a solid accuracy (over 80%) in predicting bankruptcy.
A score above 3 signifies a shallow of bankruptcy, while anything lower than 1.8 should be taken as a red flag. The formula differs depending on the nature of the company, and should you wish to learn more about it, you can start by following this link to its Wikipedia article.
This score was developed in 1967 by Professor Edward Altman and has displayed a solid accuracy (over 80%) in predicting bankruptcy.
A score above 3 signifies a shallow of bankruptcy, while anything lower than 1.8 should be taken as a red flag. The formula differs depending on the nature of the company, and should you wish to learn more about it, you can start by following this link to its Wikipedia article.
