What financial ratios to look at when trading penny stocks?

All you need to know about a financial ratio is that’s a number out of company’s financial statement divided by another number of the same. Very straightforward but yet powerful in terms of investment valuations. There are a lot of wise investors out there who are keen on investing into various penny stocks but still a little pessimistic about the regulatory standards of the microcap market. Financial ratios are like having a life jacket, so you would rather ride the waves of profit than end up being broke.

Penny stocks have always been very attractive due to low costs. Financial ratios help you place them and blue chip companies on equal ground to compare financial numbers and determine whether a penny stock investment is viable or not. Also, you may keep track of company’s operating cash flow to see if they are improving or rather declining. Other than knowing this, you need to analyze these figures which allow to get a detail picture of the company’s present and future potential. For penny shares only a handful of financial ratios is helpful but by using them, you wind up the size of analyzed entities at a high level. You also need to bear in mind that new starters are not making any money, so gross/net margins are not considered.

Liquidity Ratios: including current ratio, cash ratio, quick ratio and operating cash flow ratio are the ones that must be investigated for microcaps. Given these securities often try to get free of the short-term obligations, liquidity ratios of 0.5 indicate that the company holds more liabilities than assets. In other words, the business is unable to cover its short-term debts.

Leverage Ratios: leverage ratios consider only long-term debts which can be covered by the companies. In this case, we have two important indicators of such: debt ratio (Total liabilities/Total assets) and interest coverage ratio (Earnings Before Interest and Taxes/Interest Expense). First ratio allows to see if the total debt is squeezing or growing while second ratio is here to determine level of debt management in terms of adequate earnings to interest expenses.

Performance Ratios:such as operating/gross/net margins are concerned with the earnings generated at each leg of the income statement. However, when it comes to profit margins we should take into account that these values are relatively small at a seed level/initial stage – hence we can’t fully analyze them in the context of penny stocks and should better focus on other metrics.

Valuation Ratios: last but not least is valuation ratios which identify how much companies are worth as regards investment potential. These allow to measure attractiveness of penny stocks as to being either undervalued or overvalued: price to earnings ratio (Current Share Price/Earnings Per Share) indicates how much a prospective investor needs to put in to receive a 1 USD return but these measures become useless if earnings are inflated. In this case, price to sales ratio (Current Share Price/ Sales Per Share) is more efficient as it takes in annual sales as denominator.

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