One of the ways of determining if
a particular stock is strong is by looking at that company's
Balance Sheet. The balance sheet will illustrate what
the company owns (current & long term assets), what
it owes (short & long term debt) and its position
of financial liquidity. You wouldn't want to invest in
a company that has trouble paying its short term bills
now would you?
In this article, we will look at
3 of the common accounting ratios that help determine
the financial position of a company.
1) Cash Conversion Cycle
The Cash Conversion Cycle
tells you about the working capital position of a firm.
The Working Capital is Current Assets - Current Liabilities.
The Cash Conversion Cycle tells you whether the company
is efficiently managing 2 of its most important assets:
Accounts Receivable and Inventory.
The formula for Cash Conversion
Cycle is:
Cash
Conversion Cycle = Days Inventory Outstanding
+
Days Sales Outstanding
-
Days Payable Outstanding |
The above formula is calculated in
days and shows the # of days it takes to fully collect
proceeds from sales and the amount of time it takes for
inventory to turn itself over. Once you calculate the
# of days from the Cash Conversion Cycle formula, you
should consider it with the industry standard.
You as a stock investor need to investigate
this ratio over a timeframe of 5-10 years and compare
it with that industry in general. Decreases in the # of
days from the Cash Conversion Cycle formula shows a sign
of consistent improvement and growth. However, if the
# of days increases over the period of 5-10 years, this
shows a sign of recent inefficiency of the management
and operations of the firm.
2) Fixed Asset Turnover Ratio
Fixed Assets such as Property, Plant
& Equipment is one of the largest group of capital
assets that a company can own. Some firms rely heavily
on their capital assets in order to carry out their business
operations. These are known as capital intensive firms.
Examples include natural resources and capital equipment
manufacturers. Compare this with businesses such as service
companies (McDonalds) or computer software companies.
The formula for Fixed Asset
Turnover Ratio is:
Fixed
Asset Turnover = Net Sales / Average Fixed Assets
|
The Average Fixed Assets is calculated
by adding up the Property, Plant & Equipment assets
of the company over the last 2 years, and dividing this
# by 2. These numbers are derived from the balance sheet
of the firm.
The Fixed Asset Turnover ratio tells
you the efficiency of management in using the Property,
Plant & Equipment to generate Net Sales. This ratio
tells you whether the fixed capital assets of the firm
are used productively or not. The higher this #, the better.
Once you've determined the Fixed Asset Turnover of a company,
you should compare it with that of its competitors and
general industry.
3) Return on Assets Ratio
Return
on Assets = Net Income / Average Total Assets |
The Return on Assets ratio tells
you about the profitability of the company and how efficiently
it uses its assets to create sales and profit. The Average
Total Assets is calculated by adding up the Total Assets
of the company over the last 2 years, and dividing this
# by 2. These numbers are derived from the balance sheet
of the firm.
The Return on Assets ratio is output
in percentage format. The higher the percentage, the better.
