The stock market has been history’s greatest wealth creator for the average person, but there are inherent risks with investing.
If you’re investing in stocks, it’s important to be able to understand and analyze a company’s financial metrics so you can understand the potential risks a company might face.
Here are some of the key metrics investors can analyze to make more informed investment decisions.
Table of Contents:
- Leverage Ratios
- Profitability Ratios
- Liquidity Ratios
- Efficiency Ratios
- Comprehensive Risk-Assessment Metrics
Let’s dive in!
1. Leverage Ratios
Leverage ratios assess the extent to which a company utilizes debt to finance its operations.
High reliance on debt can amplify returns but also increases financial risk, especially during economic downturns.
Debt-to-Equity (D/E) Ratio
The Debt-to-Equity ratio compares a company’s total debt to its shareholders’ equity, indicating the proportion of debt financing relative to equity. It’s one of the easiest ways to analyze a company’s balance sheet.
A higher D/E ratio suggests greater financial leverage, which can be risky if the company faces earnings volatility.
Calculation: Debt-to-Equity Ratio = Total Debt / Shareholders’ Equity
Example: Consider Company A with total liabilities of $500 million and shareholders’ equity of $250 million. Its D/E ratio would be 2.0, implying that for every dollar of equity, there are two dollars of debt. This high leverage could be concerning if the company encounters financial challenges.
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Interest Coverage Ratio
The Interest Coverage Ratio assesses a company’s ability to meet its interest payment obligations from its operating earnings.
A lower ratio may indicate potential difficulties in servicing debt, increasing financial risk.
Calculation: Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expenses
Example: If Company B has an EBIT of $200 million and interest expenses of $50 million, its interest coverage ratio would be 4.0.
This means the company earns four times its interest obligations.
We like to see that a company has an interest coverage ratio greater than 3.0, so this suggests the company can comfortably pay the interest on its debt.
2. Profitability Ratios
Profitability ratios measure how well a company generates earnings.
Higher profitability often indicates that a company has a competitive advantage and operational efficiency, which gives the company a stronger long-term position.
Return on Equity (ROE)
Return on Equity measures how effectively management uses generates profits compared to shareholders’ equity.
Calculation: ROE = Net Income / Shareholders’ Equity
A low ROE might suggest the company doesn’t have a strong competitive advantage or isn’t very profitable.
Example: Apple’s 157% ROE in 2024 means that for every $100 in shareholders’ equity, the company generated $157 in net income. This is extraordinary profitability, as high-quality businesses typically sustain 15-20% returns on equity over the long-term.
Return on Invested Capital (ROIC)
ROIC evaluates how effectively a company turns invested capital into profits. It’s considered one of the most reliable indicators of managerial performance and business quality.
Calculation: ROIC = Net Operating Profit After Tax (NOPAT) / Invested Capital
Example: Apple’s 70% ROE in 2024 means that for every $100 in invested capital in the company, Apple generated $70 in net income. This is extraordinary profitability, as high-quality businesses typically sustain 15 returns on capital over the long-term.
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3. Liquidity Ratios
Liquidity ratios evaluate a company’s ability to meet its short-term obligations, providing insight into its financial flexibility.
Current Ratio
The Current Ratio measures a company’s ability to pay off its short-term liabilities with its short-term assets. A ratio below 1 may indicate potential liquidity issues.
Calculation: Current Ratio = Current Assets / Current Liabilities
Example: If a company has current assets of $300 million and current liabilities of $200 million, its current ratio would be 1.5, suggesting it has sufficient assets to cover its short-term obligations.
Quick Ratio
Also known as the acid-test ratio, the Quick Ratio assesses a company’s ability to meet short-term liabilities without relying on inventory sales. A lower ratio may indicate liquidity concerns.
Calculation: Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Example: If a company has current assets of $500 million, inventory worth $200 million, and current liabilities of $300 million, its quick ratio would be 1.0, indicating it can meet its short-term obligations without selling inventory.
4. Efficiency Ratios
Efficiency ratios assess how effectively a company utilizes its assets and manages its liabilities.
Asset Turnover Ratio
The Asset Turnover Ratio measures a company’s ability to generate sales from its assets. A lower ratio may indicate inefficiencies in asset utilization, potentially increasing investment risk.
Calculation: Asset Turnover Ratio = Net Sales / Average Total Assets
Example: If a company has net sales of $500 million and average total assets of $1 billion, its asset turnover ratio would be 0.5, indicating it generates 50 cents for every dollar invested in assets.
This could suggest the company’s assets are underutilized, because an asset turnover of 1 is generally considered efficient.
Inventory Turnover Ratio
The Inventory Turnover Ratio measures how often a company’s inventory is sold and replaced over a period.
Low turnover that inventory isn’t selling, which means the company could be tying up capital unnecessarily.
An inventory turnover of 10 is generally considered efficient, while a turnover of under 4 is more inefficient.
Calculation: Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Example: If a company’s cost of goods sold is $200 million and its average inventory is $50 million, the inventory turnover ratio would be 4.0, meaning the company sells and replaces its inventory four times a year. A declining ratio might signal overstocking issues.
5. Comprehensive Risk Assessment Tools
Comprehensive risk assessment tools provide a holistic view of a company’s financial health by combining multiple financial metrics.
Piotroski F-Score
The Piotroski F-Score is a number between 0 and 9 that assesses a company’s financial strength, with higher scores indicating better financial health.
It evaluates profitability, leverage, liquidity, and operating efficiency.
Score Range:
- 0 to 3 = Weak financial health
- 4 to 6 = Average financial health
- 7 to 9 = Strong financial health
For each one of the components that a company has, it receives a point.
1. Profitability (4 points total)
- Return on Assets (ROA) > 0
The company is profitable. - Operating Cash Flow > 0
The business generates real cash. - Change in ROA > 0
Profitability is improving year over year. - Operating Cash Flow > Net Income
Earnings are backed by cash (suggests earnings quality).
2. Leverage, Liquidity, and Source of Funds (3 points total)
- Change in Leverage (Long-Term Debt/Assets) < 0
The company is reducing its debt burden. - Current Ratio > Prior Year
Liquidity is improving (more able to cover short-term obligations). - No New Shares Issued
The company did not dilute shareholders during the year.
3. Operating Efficiency (2 points total)
- Gross Margin > Prior Year
Margins are expanding, signaling better cost control or pricing power. - Asset Turnover > Prior Year
The company is using its assets more efficiently to generate revenue.
A score of 7 or higher suggests the company is financially strong.
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Altman Z-Score
The Altman Z-Score predicts the probability of a company entering bankruptcy within two years, using five financial ratios. It combines five financial ratios into a single score to assess profitability, leverage, liquidity, solvency, and operating efficiency.
Formula:
Z-Score = 1.2 × (Working Capital / Total Assets)
+ 1.4 × (Retained Earnings / Total Assets)
+ 3.3 × (EBIT / Total Assets)
+ 0.6 × (Market Value of Equity / Total Liabilities)
+ 1.0 × (Sales / Total Assets)
Breakdown of the Five Inputs:
- Working Capital / Total Assets: Measures short-term liquidity
- Retained Earnings / Total Assets: Shows how much profit the company has reinvested
- EBIT / Total Assets: Captures operating efficiency relative to the asset base
- Market Value of Equity / Total Liabilities: Reflects how much buffer equity holders provide against liabilities
- Sales / Total Assets: Evaluates how efficiently the company uses its assets to generate revenue
Interpretation of the Score:
- Above 2.99: Low risk of bankruptcy (safe zone)
- 1.81 to 2.99: Some risk (gray zone)
- Below 1.81: High risk of bankruptcy (distress zone)
Example: If Company L has a Z-Score of 1.5, it falls into the distress zone, signaling a high risk of bankruptcy. Investors should exercise caution and conduct further analysis before investing.
FAQ Section
How does the Debt-to-Equity (D/E) ratio indicate a stock’s riskiness?
The Debt-to-Equity (D/E) ratio measures a company’s reliance on debt compared to equity. A higher ratio implies greater financial risk, especially if earnings decline.
Why is the Interest Coverage Ratio important for evaluating stock risk?
The Interest Coverage Ratio shows if a company can comfortably pay interest expenses from its operating earnings. Lower ratios suggest potential struggles to meet debt payments, indicating higher risk.
What does a low Return on Assets (ROA) indicate about a company’s risk level?
A low Return on Assets (ROA) signals inefficient use of assets to generate profits. This inefficiency can indicate management issues or competitive disadvantages, increasing investment risk.
How does the Current Ratio help investors assess financial risk?
The Current Ratio indicates if a company has sufficient short-term assets to cover its short-term liabilities. A ratio below 1.0 could suggest liquidity problems, heightening financial risk.
Why is the Piotroski F-Score useful for evaluating investment risk?
The Piotroski F-Score rates financial strength from 0 to 9, based on profitability, liquidity, and operational efficiency. Higher scores signal better financial health and lower investment risk.
TIKR Takeaway
Analyzing key financial metrics such as leverage, profitability, and liquidity ratios helps investors effectively identify and manage stock investment risks.
This can help investors see if a stock might offer strong long-term returns.
The TIKR Terminal offers industry-leading financial data on over 100,000 stocks, so if you’re looking to find the best stocks to buy for your portfolio, you’ll want to use TIKR!
TIKR offers institutional-quality research for investors who think of buying stocks as buying a piece of a business.
Disclaimer:
Please note that the articles on TIKR are not intended to serve as investment or financial advice from TIKR or our content team, nor are they recommendations to buy or sell any stocks. We create our content based on TIKR Terminal’s investment data and analysts’ estimates. Our analysis might not include recent company news or important updates. TIKR has no position in any stocks mentioned. Thank you for reading, and happy investing!
