The stock market is a great place to invest and build wealth long term. Recently a number of the big brokerage services have gone to charging zero trading fees. This savings is a boon for small investors.

A good strategy for building wealth is to buy and hold stocks that you like. If you use a product or service, check out if the company is publicly traded and think about its prospects going forward.

It is not about timing the market but time in the market that determines the best chance of making gains and accumulating wealth.

There are no guarantees of making money. The stock market can be volatile. But over the long term, it has historically performed better than any other class of investment.

Examining a company’s financial health is called fundamental analysis.

You can make informed decisions about what companies to invest in by analyzing their financial statements with financial ratios.

All public companies file audited financial statements with the Securities and Exchange Commission each year in the form of a document called a 10K. They are required to update these financials quarterly with a 10Q.

You can find these documents on the SEC website www.sec.gov by searching their name in the EDGAR section of the website.

Here is a primer on financial ratios to use to analyze and compare companies and make value-based investing decisions.

A wealthy person is simply someone who has learned how to make money when they’re not working.

- Robert Kiyosaki

Financial Ratios

Financial ratios are powerful tools used to assess company upside, downside, and risk.

There are four main categories of financial ratios: liquidity ratios, profitability ratios, activity ratios, and leverage ratios. These are typically analyzed over time and across competitors in an industry.

Using ratios “normalizes” the numbers so you can compare companies in apples-to-apples terms.

Liquidity and Solvency

Solvency and liquidity are both refer to a company’s financial health and viability. Solvency refers to an enterprise’s capacity to meet its long-term financial commitments. Liquidity refers to an enterprise’s ability to pay short-term obligations. Liquidity is also a measure of how quickly assets can be converted to cash by being sold.

A solvent company is one that owns more than it owes. It has a positive net worth and is carrying a manageable debt load. A company with adequate liquidity may have enough cash available to pay its bills, but may still be heading for financial disaster down the road. In this case, a company meets liquidity standards but is not solvent.

Healthy companies are both solvent and possess adequate liquidity.

Liquidity ratios determine whether a company has enough current asset capacity to pay its bills and meet its obligations in the foreseeable future (current liabilities).

Solvency ratios are a measure of how quickly a company can turn its assets into cash if it experiences financial difficulties or bankruptcy.

Liquidity and Solvency ratios measure different aspects of whether or not a company can pay its bills and remain in business.

The current ratio and the quick ratio are two common liquidity ratios. The current ratio is current assets/current liabilities and measures how much liquidity (cash) is available to address current liabilities (bills and other obligations). The quick ratio is (current assets — inventories) / current liabilities.

The quick ratio measures a company’s ability to meet its short-term obligations based on its most liquid assets and therefore excludes inventories from its current assets. It is also known as the “acid-test ratio.”

The solvency ratio examines the ability of a business to meet its long-term obligations. Lenders and bankers commonly review solvency. The ratio compares cash flows to liabilities. The solvency ratio calculation involves the following steps:

All non-cash expenses are added back to after-tax net income. This approximates the amount of cash flow generated by the business. You can find the numbers to add back in the Operations section of the Cash Flow Statement.

Add together all short-term and long-term obligations. This summation is the Total Liabilities number on the Balance Sheet. Then divide the estimated cash flow figure by the liabilities total.

The formula for the ratio is:

(Net after-tax income + Non-cash expenses)/(Short-term liabilities + Long-term liabilities)

A higher percentage indicates an increased ability to support the liabilities of the enterprise over the long-term.

Remember that estimations made over the long term are inherently inaccurate. Many variables can impact the ability to pay in the long run. Using any ratio used to estimate solvency is subject to a degree of uncertainty.

Profitability Ratios

Profitability ratios are ratios that help discern how profitable a company is. To be profitable, a company has to cover costs. The breakeven point and the gross profit ratio address the dynamics of cost coverage in different ways.

The breakeven point calculates how much cash a company must generate to break even with their operating costs.

The gross profit ratio is equal to (revenue — the cost of goods sold)/revenue. This ratio provides a quick snapshot of expected revenue that can cover the overhead expenses and fixed costs of operations.

Some additional examples of profitability ratios are profit margin, return on assets, and return on Equity. The higher the value in these ratios, the more profitable a company is. Having a higher value relative to a competitor’s ratio, or the same ratio from a previous period, is indicative that the company is performing relatively well and going in the right direction.

Return on Equity

Return on Equity (ROE) = Net Income / Average Shareholders’ Equity

Earnings per Share

Earnings per share (EPS) is the portion of the company’s profit, which is allocated to each outstanding share of common stock.

Earnings per share is an excellent indicator of the profitability of any organization, and it is one of the most widely used measures of profitability.

Activity Ratios

Activity ratios show how well management is doing managing the company’s resources. Activity ratios measure company sales relative to another asset account.

The most common asset accounts used are accounts receivable, inventory, and total assets. Since most companies have a lot of resources tied up in accounts receivable, inventory, and working capital, these accounts are in the denominator of the most common activity ratios.

Accounts receivable (AR) is the total amount of money due to a company for products or services sold on a credit account. The length of time until AR is collected is critical. A company must finance that expected revenue in some way. You can’t pay bills with AR.

The accounts receivable turnover shows how rapidly a company collects what is owed to it and indicates the liquidity of the receivables.

Accounts Receivable Turnover = Total Credit Sales/Average Accounts Receivable

The average collection period in days is equal to 365 days, divided by the Accounts Receivable Turnover.

Another ratio that helps gain insight into AR collection is:

Average Collection Period = 365 Days/Accounts Receivable Turnover

Analysts frequently use the average collection period to measure the effectiveness of a company’s ability to collect payments from its credit customers. The average collection period should be less than the credit terms that the company extends to its customers.

A significant indicator of profitability is the ability to manage inventory. Inventory is money and resources invested that do not earn a return until the product is sold.

The longer inventory sits, the less profitable a company can be. A higher inventory turnover ratio indicates more demand for products, better cash management, and also a reduced risk of inventory obsolescence.

The best measure of inventory utilization is the inventory turnover ratio. You calculate it as either the total annual sales or the cost of goods sold (COGS), divided by the cost of inventory.

Inventory Turnover = Total Annual Sales or Cost of Goods Sold/Average Inventory

Using the cost of goods sold in the numerator can provide a more accurate indicator of inventory turnover because it allows a more direct comparison with other companies. Different companies have different markups to the sale price, and this can obscure apples-to-apples comparison.

The average inventory cost is usually used in the denominator to compensate for seasonal differences.

Leverage ratios

Leverage ratios analyze the degree to which a company uses debt to finance its operations and assets. The debt-to-equity ratio is the most common. You calculate this ratio as:

(Long-term debt + Short-term debt + Leases)/ Equity

Companies with high debt ratios need to have steady and predictable revenue streams to service that debt. Companies whose revenues fluctuate and are less predictable should rely more on Equity in its capital structure. Leverage also has obvious implications for solvency.

Startups rely almost entirely on Equity as they have no revenues or very uncertain revenues that can service debt.

DuPont Analysis

The DuPont Corporation developed DuPont analysis in the 1920s as a tool to assess their investments across their various companies and operations. As a conglomerate, they need a tool to evaluate the relative performance of their different business units.

Dupont analysis is a tool to make decisions about where and how to allocate resources. It has become a widely adopted managerial and investment tool.

What drives ROE?

DuPont Analysis analyzes Return on Equity by deconstructing it into its main drivers.

DuPont Analysis is an expression, which breaks return on Equity (ROE) into three parts.

The basic formula is:

ROE = (Profit margin)*(Asset turnover)*(Equity multiplier) =

(Net Income/Sales)*(Sales/Assets)*(Assets/Equity) = (Net Income/Equity)

The three constituent parts are:

· Profitability: measured by profit margin

· Operating efficiency: measured by asset turnover

· Financial leverage: measured by equity multiplier

DuPont analysis enables you to understand the source of superior (or inferior) return by comparison with companies in similar industries or between industries. It also provides a deeper level of understanding by parsing apart the significant variables and drivers of Return on Equity. And ROE is undoubtedly a metric that equity investors (stock investors) find essential.

Summary

Financial ratios are powerful tools. Use them to assess company upside, downside, and risk when you are evaluating stock investments.

There are four main categories of financial ratios:

· Liquidity ratios,

· Profitability ratios,

· Activity ratios,

· Leverage ratios.

These are typically analyzed over time and across competitors in an industry.

Ratios “normalize” the numbers so you can compare companies in apples-to-apples terms.

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