By Stella Goh – Market Data Analyst | 14 March 2018
Fundamental analysis is a method to analyse a business by getting more understanding of a company background business and their future direction. It will be including examining the annual reports and financial statements, using some of the simplified calculation to gauge the effectiveness of the company.
Let’s look at the five fundamentals ways below:
1. Current Ratio
The current ratio (also known as liquidity ratio) is a ratio which used to measure the ability of a company to pay off their debts and obligations (debts and account payables) by using its assets (cash, marketable securities, inventory, and account receivables). The current ratio divides current assets by its current liabilities to come up with a value which indicates the company’s ability to cover its debts and obligations.
For examples, a current ratio of 4 means the company has four times more current assets than current liabilities. Therefore, it indicates that the companies have more to than enough asset to pay off their debts without needing to sell off their long-term asset.
Which mean a company that has a current ratio of 1 or more should not face any liquidity problem. The higher it is, the better the company liquidity. However, the high current ratio may also suggest that the company is not using the current assets efficiently since extra cash can be used to reduce debts interests or reinvest in the business.
You may make a comparison of the current ratio with the companies in similar industries but not with different sector due to a different operating method in various business.
2. Price-to-Earnings Ratio
The price to earnings ratio is one of the most widely used. Also known as market prospect ratio which calculated as the market price of a stock’s share divided by earnings per share to find out the value of investors is willing to shell out for each dollar of a company’s earning. In other words, PE ratio helps investors to analyse how much the stocks worth based on current earnings.
This ratio is beneficial to evaluate what is the stock’s fair market value should be by predicting the future earnings per shares. High PE ratio indicates that the market participants are bullish on the stock and they have an expectation on the company to post their higher earnings growth going forward. However, high PE ratio may also a signal that the overvalued stock and a lower PE ratio suggests the vice versa. Besides, when a company does not have any earnings or is posting losses, the PE can be expressed as N/A, so it is possible to get a negative PE ratio.
The PE ratio may compare with its peers having parallel and must always relative to the company’s position in the life cycle and relative to its peers in the same industry and the market as a whole. For examples, new companies may have higher PE ratio if they have high growth of prospect since their current earnings are minimal but they spend more money to grow.
3. Price-to-Book Ratio
Price-to-Book Ratio (also known as a market-to-book ratio) is a ratio which used to compare the stock’s market price value to its book value. This ratio calculated by dividing the company’s current share price by its book value of equity. This ratio also gives some idea of whether you’re paying too much for what would be left if the company went bankrupt immediately.
Price-to-book ratio helps investors for reality check who are seeking for growth at reasonable price. A high PB ratio indicates that there will be a robust future expectation of earnings due to the perceived growth opportunities and some competitive advantages. It was due to the company has been earning a very high return on its assets. However, the high the PB ratio also indicates that the share price overvalued.
The intangible assets in Price-to-book ratio shall be excluded to avoid the calculation the price-to-book ratio to be misleading. Low PB ratio could mean that the stock is undervalued. However, under certain circumstances of financial distress, bankruptcy or expected plunges in earnings power, a company’s P/B ratio can be dive below one due to the accounting principles do not recognise the brand value and other tangible assets.
4. Total Debt to Equity Ratio
The standard overall debt-to-equity ratio can be a more reliable indicator of the financial viability of a business since it includes all the short-term debts. This ratio can help a firm to plan for asset financing and to the extent whether shareholder’s equity able fulfil the obligations to the creditors in the event of loss from the business.
A financial healthy company’s leverage shall be higher when total debt to equity ratio is high due to the company must meet their principal and interest on its obligations. Therefore, the companies with high debt to equity ratios might look riskier due to their liabilities more than equity.
Some of the potential creditors may be reluctant to give financing to a company with high debts position. However, the magnitude of the debts should depend on the type of business. For examples, based on ordinary circumstances most of the bank’s debt to equity ratio will be considered risky, but due to their assets generated are very liquid, their ability to pay the debt will much better than the rest. For the second example, a utility sector company can afford a higher ratio than a manufacturer company due to utility company had more stable and consistent earnings.
5. Time Interest Earned Ratio
Time interest earned ratio (also known as interest coverage ratio), is a ratio which used to measure how much of the proportionate income can be used to cover the interest expenses in the future.
This ratio also can be considered as solvency ratio because it used to measure a firm’s ability to make for interest and debt payments. These payments are treated as fixed expenses because the interest payments set on a long-term basis. Therefore, if the company could not make payments, the company may go into bankruptcy or to ceased to operate.
The time interest ratio stated in numbers as opposed to a percentage. A ratio of 4 times indicates that the company has made enough income to pay for its total interest expenses over four times. Most of the creditors favour this type of company because of their ability to pay interest when it’s due.
To be advised that ratios measuring may indicate the effectiveness of the company management to deal with day to day operation but does not indicate the future stock price movement. You may be advised to use other information or strategies such as technical analysis or some qualitative metrics such as management quality.