In the previous articles in this series, we have seen metrics that help assess how to pick a stock. Unfortunately, there is no golden metric that unlocks all doors and provides the answer to which stock to buy – finding a company that checks every box is a fairly challenging task. The financial health of an organisation can be assessed using four main parameters – liquidity, solvency, profitability, and operating efficiency. In addition to these parameters, we will also talk about the subjective aspects of assessing a company.
Liquidity
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Liquidity is defined as the sum of cash and equity that can be easily traded for cash. This is primarily to fulfil short-term debt and obligations and is a primary indicator of an organisations financial health. The quick ratio, sometimes called the acid test, is an effective metric to analyse liquidity. It is the ratio of current equity to current liabilities. It does not include any inventory and the current portion of debt from liabilities.
Solvency
Solvency is an organisation’s ability to meet obligations sustainably over time. This is where it differs from liquidity. Solvency ratio is the calculation of long-term obligations in relation to the possessed equity. The debt-to-equity (D/E) ratio is often used to assess solvency. It assesses the level of debt against equity and it says something about investor confidence in the organisation. Irrespective of the industry or the nature of a business, a declining trend in the D/E ratio is a good indicator of financial stability.
Operating Efficiency
Operating efficiency is best assessed by the operating margin of the organisation. It not only indicates the basic operational profit margin (after deduction of operational expenses) but also provides a view of the cost control imposed by the management. An organisation’s long-term sustainability is directly related to the effectiveness of its management.
Profitability and Bottom Line
We can analyse metrics all day and all night, but the truth remains – the bottom line and net profitability. Organisations can survive for years while incurring losses and operating on contributions of creditors and investors. To survive in the long term, organisations should attain and sustain profitability. Net margin – the ratio of profits to income – is often used to understand profitability. The ratio helps understand the status better than a dollar value as it takes accounts for the size of the organisation. i.e. a small company might have a small (dollar) amount of profit when compared to a larger one. But the percentage of profit might be higher for the smaller company.
Dividend Track Record
Dividend payments account for a lot of the returns produced by shares. Dividends are paid most often by stable companies and the studying dividend payment over time gives a good idea of how the organisation is performing. If a company is doing badly, dividends are often the first to take a cut. The contrary is also true, a stable company with expects a sustainable future will continue to maintain, if not grow, dividend payments.
When on eToro, navigate to the stock you are interested in. You can find more information about the aspects mentioned in this article in the Stats and Research tabs. The points above are the quantitive aspects that you can try to understand a company. In addition to those, it is also important to understand certain subjective aspects of a company.
Management Team & Board Members
Investing in the shares issued to the public by the company represents an ownership in the company. Which means that the investor entrusts the management team to make the right call with his/her money. The board of directors is expected to watch over the management, ensuring proper conduct. Therefore, if the management and board of directors do not garner your trust, you should think twice about investing in the company.
Promises With Respect To Results
Companies have creative ways of portraying results to fit into the promises they make. It is important to double-check that they have met the promises they have made and it is not all accounting puffery.
If you have not already, do read about other important metrics of stock picking in our series. For the rest, feel free to practice using the eToro Demo Practice Account.
This Article is Part of A Total guidance list on How to pick individual stocks, make sure you go by the article one by one to get a bigger understanding of the total picture. 😉
- How to Pick an individual stock Part 1 - The Strategy
- How to Pick an individual stock Part 2 - 5 metrics to look at when stock picking
- How to Pick an individual stock Part 3 - P/E Ratio (Price-Earnings ratio)
- How to Pick an individual stock Part 4 - Earnings Per Share
- How to Pick an individual stock Part 5 - Dividend Yield
- How to Pick an individual stock Part 6- Company History And Strength
- How to Pick an individual stock Part 7- Debt-Equity Ratio
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