Look before you leap. This proverb adequately sums up the realities of foresightful and circumspect investing in the stock market, rather than jumping at a stock precipitously. Amid earnings season, Stocks & Securities Ltd (SSL) would like to take the opportunity to go “back to the basics” with a few tips to improving your investment decisions.

Ratios are one of the most effective tools used to analyze a Company’s performance. They are used to chart progress over time, uncover trends and point to potential problem areas. They are typically grouped into five categories: Liquidity, Asset, Probability, Market and Debt. As the name suggests, liquidity ratios give an overview of the Company’s short-term financial solvency and are probably the most commonly used of financial ratios. Liquidity ratios indicate whether a Company is able to meet its current financial obligations by measuring the ability of its assets to cover its liabilities. Though this measure varies from industry to industry, the standard current ratio for a healthy business is two and greater than one at minimum.

Asset ratios can be used to determine how efficient a Company is in its operations and use of its assets. The most commonly used asset ratio is the inventory turnover. This ratio may be calculated by dividing annual average inventory by total sales. A good ratio is subjective to the type of inventory the Company holds but a higher ratio is generally more appealing since inventory is the least liquid asset.

Debt ratios attempt to measure the Company’s use of debt, in other words, how leveraged the Company is. The total debt ratio, calculated by dividing total debt by total assets, seeks to ascertain if the Company would cover all its debt if all is assets were sold. A value less than one indicates that the Company would be unable to do so. Similarly, the debt to equity ratio indicates the proportion of the Company’s assets that is financed by debt versus equity and is calculated by dividing total liabilities by shareholder’s equity. A ratio ranging from 1:1 to 4:1 is generally attractive.

While liquidity and assets ratios look at the Company’s solvency and efficiency, profitability ratios are often considered the most important indicators of financial success. These ratios reflect the joint effort of asset and debt management while demonstrating the performance and potential growth of the Company. A commonly used ratio is Return on Assets (ROA) which indicates the average return the Company generates on its assets. Similarly, Return on Equity (ROE) indicates the return the Company is generating on the money invested by shareholders.

On the other hand, market valuation ratios show how the market values the Company. One of the most commonly used indicators is the Price to Earnings (P/E) ratio which shows how much investors are willing to pay per unit of current earnings.

Now that the ratios have been calculated the next step for value-added analysis is comparison. A good strategy is to compare the ratios with industry averages, competitor’s ratios and the Company’s previous ratios. On their own, the ratios are meaningless; the way in which they are analysed is the key to unlocking an effective conclusion for your investment decisions. For example, you know that a high inventory turnover is generally positive, however an unusually high turnover when compared with the industry average could mean the Company is losing sales because of inadequate stock on hand. Similarly, a profit margin is meaningless by itself, however if competitors have a higher margin then it indicates that the Company is less profitable than its industry peers.

To put this into perspective, Salada Foods Ltd’s (SALF) ROE of 22.29 per cent does not automatically translate to a healthy Company. However, when comparing it with another Company in the Manufacturing industry, Montego Freeport Ltd (MFP), which has a ROE of 4.97 per cent, SALF deems healthier than its peer. In fact SALF boasts a sound management team and has a track record of growth where as MFP is not a fundamentally sound Company and has produced inconsistent results.

Taking a look at market valuation ratios, at a price of $6.00, Jamaica Broilers Group Ltd’s (JBG) P/E of 6.5 is one of the lowest in the Manufacturing industry, presenting it as an attractive opportunity for investors. Looking across the industry, Desnoes & Geddes Ltd’s (DG) P/E of 14.52 more than doubles JBG’s, making it a less attractive investment.

The bottom line is that a prudent investor will not leap before he jumps – he will effectively analyse key financial ratios, examine trends in financial data and make adequate comparisons. These steps are integral to making effective and promising investment decisions.

Sutanya Chedda is Research Administrator at Stocks & Securities Ltd. She can be contacted at schedd@sslinvest.com.