Current ratio is current assets divided by current liabilities, an important indicator of a company’s ability to meet debt obligations. The higher the ratio the better, as it means the company has more liquidity. For example, a current ratio of 2.5 means that the company’s current assets, if liquidated, would be equal to 2.5 times the company’s current liabilities.
Debt ratio is total liabilities divided by total assets, indicating how much of the company’s current possessions have been financed with debt. For example, a debt ratio of 30% indicates that 30% of the company’s assets were bought with borrowed money. The question of leverage depends to a great extent on the economic climate. When money is expensive (i.e. interest rates are high) a large debt ratio can spell trouble, as the cost of servicing the debt may become unmanageable. When interest rates are low, on the other hand, high debt ratios matter less, as cheap borrowing allows a company to grow faster than would otherwise be possible.
Inventory turnover is cost of goods sold divided by value of inventories, indicating how much product a company holds in order to meet sales requirements. Generally, the higher this figure the better, as it means less product is being held in warehouses at any one time (i.e. dead money). The sector plays an important part in how useful this indicator is – for example a company in a sector selling few high priced products (such as a shipbuilder) will tend to have a better inventory turnover than, for example, a supermarket.
Stock Price Valuation
Having analyzed the above factors, several ‘models’ can be employed to determine if a company’s stock is over or undervalued. Examples might include ‘dividend’ models which focus on the net present value of a company’s dividends, or earnings models which examine the present value of expected earnings, and even asset models which concentrate on the value of the company’s assets. Whichever model you decide to use, you must be consistent in your application.