9 important financial indicators for the prudent investor

Before investing in shares, it is worth doing a financial analysis of the company, both to better understand the history of the company itself and to assess whether the company is sustainable and well-valued. It is important to add that the company's financial indicators give the best picture compared to other companies in the industry. As an example from our own market, the table below summarises the average financial indicators of Latvian companies by industry, while the average indicators of US companies can be found, for example, in this source from Aswath Damodaran. The already calculated indicators of individual companies listed on the stock exchange of the Baltic States can be found on the Nasdaq Baltic website under the Factsheet section, while data for international companies can be found, for example, on the Macrotrends website.

Profitability indicators
Profitability ratios are the first indicator of business success or failure:

Basically, it indicates how profitable the company is. A good amount of profit depends on the specific industry in which the company operates. These are areas where companies operate with very high net profitability (for example, mobile operators) and very low (wholesale companies).

The amount of return on equity indicates how much, in percentage terms, the company is able to earn on the capital invested in the business. For successful companies, this return should be at least 10%, but preferably 15-20%. For example, for LHV bank this figure is 16.4, while for Virši - 17.7.

Liquidity indicators
Liquidity ratios are indicators of a company's ability to meet its short-term financial obligations.


The amount of liquidity (or working capital ratio) indicates whether the company has sufficient assets to cover short-term liabilities. Current assets are those assets that can be easily converted into cash within a maximum of 1 year, while short-term liabilities are all claims that the business has to pay within the next year. A good amount of liquidity for the company is in the amount of 1.2-2. As with profitability indicators, each industry may have its own norm and therefore it is important to compare the calculation of your company's indicators with similar companies. For example, in the food retail industry, the liquidity ratio is almost always below 1.

Indicators of the amount of liabilities
These ratios measure the extent of the company's liabilities and are an important measure to ensure that the business does not expose itself to unnecessary risk by taking on too much liability. Also, these indicators are used by financiers, evaluating the company's ability to attract additional money for business.

The amount of equity ratio indicates how much of the company's assets are financed by the owners' funds. The closer this indicator is to 100%, the more the company finances with equity capital. Since equity is usually more expensive (investors expect a higher return on it) than debt financing, it is rare for a company to operate without debt.

This ratio indicates how much the company relies on liabilities for its financing. Again, it is important to compare this indicator with the average size among companies in your field. A low amount of the indicator may indicate that the company is not using the growth opportunities that would be provided by additional credit financing. On the other hand, a high indicator (compared to the industry average) may indicate that the business is exposed to additional risk due to excessive loans. Typically, a good loan-to-equity ratio is in the 1-3 range.

Performance indicators
Efficiency indicators indicate how well the company uses its resources to generate turnover and profit. Each industry may have a different indicator that is most important for evaluating efficiency. For example, in retail, inventory circulation would be relevant, while in a consulting company - income per employee. On the other hand, for example, the calculation of debtor days can indicate how effectively the company ensures that the goods/services it provides are paid on time.

If a company's accounts receivable days are above the industry average, it potentially indicates poor customer payment discipline or that the company is offering customers more favorable terms than competitors. A high number of accounts receivable days can also indicate that the company is not writing off bad debts.

Alternatively and more accurately, it would be better to count inventory turnover days not against the company's turnover, but against the cost of purchased goods. A high inventory turnover rate (especially relative to the industry average) indicates that the company does not need to hold large inventories (and therefore invest in working capital) to ensure sales.

Market value indicators
Market value indicators calculate the value of a company against their financial performance. More commonly used ratios would be enterprise value to earnings (PE ratio) and price to book value (PB ratio).

This ratio (also called payback years) essentially shows how many years an investment in a company's stock will pay for itself (assuming earnings remain constant). A higher P/E ratio compared to other similar companies may indicate that the stock is overvalued, while a lower P/E ratio may indicate that it is undervalued. The faster the company and the economy it operates in grow, the higher the PE ratio usually is. For example, the average PE ratio of companies traded on the US stock exchange is 21, while in the Baltics it is around 16 and in Greece 6.5.

The P/B ratio is calculated by dividing the share price by its book value per share. The PB ratio is used to compare individual companies in the industry, but most often - banks. If the PB ratio is below 1, it means that basically investors do not see a great perspective for the company's operation and the company's share can be bought at a discount from its accounting value. For example, western countries, especially European banks, can be bought for a long time at a price below the book value of these shares. For the largest European bank, HSBC, this ratio is 0.83, for BNP Paribas - 0.57, and for Deutsche Bank - 0.29. For comparison, LHV bank's PB ratio is 2.47 and Coop bank's - 1.55 (data of October 2, 2023)

Summary
It is important to note again that financial ratios should not be used in isolation. When evaluating the financial performance of each business, the company's industry, competitive landscape and management team should also be taken into account. It is also important to look at the trends of the company's financial indicators over time. This can help identify potential red flags for an investment, such as identifying a company that is starting to sink due to the burden of liabilities it has taken on. It is also important to remember that the analysis of financial ratios is only one of the methods and facets. The investor should evaluate a number of other aspects, including the management team, business model, competitive environment and other conditions.