Welcome to week five of the Husky Investment Tournament!
So what techniques are used when it comes to picking stocks? A great place to start is calculating some well-known ratios and see how the companies compare against each other. There are four main types of ratios that are used in practice.
Liquidity ratios indicate the financial strength of a company, and its ability to meet short-term liabilities. If a company is unable to meet its short-term obligations it is not going to be seen as a good investment. A common liquidity ratio is the current ratio. This ratio is found by taking the current assets and dividing them by the current liabilities. In this ratio, a higher number is seen as better.
Solvency ratios indicate the long-term financial viability of a company. A common ratio used in this type of ratio is the debt to equity ratio. This ratio is found by taking the total liabilities of a company and dividing them by the total amount of equity. High amounts of debt will raise some red flags.
Activity ratios tell us how the company is doing when it comes to running its operations. Looking at inventory turnover is a common activity ratio. Inventory turnover is calculated as the cost of goods sold divided by the average inventory. A high inventory turnover would indicate that the company is showing efficiency in selling its inventory.
Profitability ratios indicate whether the company is able to turn a profit in its operations. A common ratio used is the net profit margin. This is calculated by taking the net income and dividing it by the sales. A higher profit margin means that the company is able to retain more money.
It is important to note that all of these ratios are different depending on the industry that you are talking about. The airline industry may have a lot more debt than the retail stores. That is why it is important to make sure that when you’re comparing two companies that they are in the same industry. In this week’s video, Applied Portfolio Management Program alumnus and current MTU student David Golus discusses ratios in further detail.