The 5 Categories of Penny Stock Financial Ratios - dummies

The 5 Categories of Penny Stock Financial Ratios

By Peter Leeds

Investors rely on five categories of financial ratios. Within each category are several calculations to measure the various aspects of a business. You can use each of the following main categories to analyze any type or size of stock:

  • Liquidity ratios: Also sometimes called “solvency ratios,” these calculations demonstrate a company’s ability to pay its short-term debts and obligations. If it doesn’t have or isn’t able to generate enough cash, the company might not be able to keep the lights on long enough to generate a profit.
  • Activity: Also referred to as “efficiency ratios,” these demonstrate how well a company uses its assets to produce revenues. The more effective a stock is at generating sales from the value inherent in the company, the better its activity ratios.
  • Leverage: Sometimes called “debt ratios,” these calculations demonstrate the ability of a stock to repay its long-term debt.
  • Performance: In some cases, these are referred to as “profitability ratios.” They illustrate how profitable a company is at various levels of its sales and fulfillment process.
  • Valuation: These are ratios derived from the price of the shares and, as such, provide insights into the value of the stock at those levels.

Within these five categories are several financial ratio calculations, each of which can be applied to gain greater understanding of specific aspects of any company. For example, the liquidity category includes calculations for current, quick cash, and operating cash ratios, all of which provide different insights into the company’s ability to pay its short term obligations.

These are the most popular ratios for analyzing low-priced shares such as penny stocks. Several other financial ratios exist beyond the five categories mentioned; however, analysts use these other calculations far less often, or when considering larger companies. For example, because very few penny stocks pay dividends, you don’t need to calculate the dividend payout rate ratio.

Based on the manner in which the ratios are calculated, sometimes a lower number is stronger than or preferable to a higher number. For example, a P/E ratio of 8 is much better than one of 16.