The more effecient a company creates products or provides services, the more profit it generates.

How to use operating margin

Why do investors use operating margin in their analysis

To determine how much profit Rainbow is making from it’s core business.

The three steps every investor should look at:

Things to be aware of

How to calculate operating margin

Real example of Rainbow

You need the following data to determine operating margin:

Operating margin is used to calculate how much profit a company makes after variable costs of production but before paying interest and taxes. Some variable costs examples are wages, raw materials, packaging, and transaction fees. The amount of variable costs is different for each company and industry. In general, a higher operating margin is better as this implicates that a company is running efficiently. 

For investors, a higher operating margin is a good sign. Although you should always look at operating margin in the long term. If operating margin is fluctuating over the years this might be a sign that things are not running efficiently enough. It’s a way to check how much profit a company is making from its core business.

Operation earnings can be calculated in multiple ways:

If the operating ratio is below 1 that means the company is making money. The lower the operating ratio, the more efficient the company.

How to use operating ratio

Why do investors use operating ratio in their analysis

Shows if costs of creating products and or services is increasing or decreasing. The lower the operating ratio, the more efficient the company is creating products and services. 

The three steps every investor should look at:

Things to be aware of

How to calculate operating ratio

Real life example Rainbow

You need the following data to determine operating ratio:

COGS  is not always specified on the income statement. If so you can use the following calculation:

The operating ratio measures the efficiency of a company at keeping low costs while generating profits from sales. It compares the total operating expenses to the net amount of sales. The total operating expenses exists of:

Operating expenses are all the costs the company makes that are not directly tied to the production of the service or product.  Where COGS are costs that are directly tied to the production of a product or service.

Do note that COGS is not always available in the income statement. Some companies include COGS in the operating expenses while others list COGS separately. To make it even more confusing, COGS is also known as “costs of sales” and costs of sales is the same as costs of revenue.

The operating ratio tells you how efficient the company is creating its products or services while keeping prices low. In this case, a lower ratio is better. Higher or rising operating ratios might tell you that costs are rising while sales are not improving or staying the same.

How to use current ratio

Why do investors use current ratio in their analysis

Shows if the company can pay of short term debts if needed. A company that can't pay off it's short term debts might get in trouble if they have to pay off their short term debts for whatever reason. For example, markets can change due to global events like covid-19 or the war in Ukraine versus Russia. Because debts are always taken based on future income, it might become troublesome for Rainbow if something happens in the market that will cause sales to plummet.

The three steps every investor should look at:

Things to be aware of

How to calculate current ratio

Real life example Rainbow

You need the following data to determine operating ratio:

The current ratio measures if Rainbow is able to pay short-term debts (obligations). Short term in this context means all debt obligations that are about to expire within one year. The current ratio incorporates current liabilities and current assets. Current assets are all the assets a company has that are expected to be consumed or sold within standard business operations. You can find the current assets in the balance sheet. They consist of:

The current liabilities are short term obligations that are due within one year. These consist of:

The result shows an investor if Rainbow is able to pay all its short-term debts  if they were due all at once.  When the result of the above formula is below 1, then Rainbow does not have enough capital after selling all its assets to pay all short-term debts. If the ratio drops far below 1 that might indicate Rainbow is or will be in financial trouble anytime soon. 

Although this gives an investor some clues, the current ratio may also be deluded. Because owning assets does not mean the company can easily sell them. Also, Accounts receivable may be quite old (they will probably never pay) which deludes the current ratio. As with all ratios, you should only compare them between the same industries and companies.

How to use quick ratio

Why do investors use quick ratio in their analysis

Shows how fast Rainbow can pay off its short term debts. This shows if Rainbow can survive emergencies due to market changes or other reasons.

The three steps every investor should look at:

Things to be aware of

How to calculate quick ratio

Real life example Rainbow

 You need the following data to determine operating ratio:

The quick ratio measures the same thing as the current ratio, only it uses the most liquid assets a company has. Meaning, the assets that can be sold for cash the easiest and fastest.

As the quick ratio only incorporates the most liquid assets, you should also check the current ratio which also includes less liquid assets. But they may be harder to sell. 

When there are more debts than assets, that means creditors have a larger stake Rainbow than its shareholders.

How to use debt to asset ratio

Why do investors use the debt to asset ratio in their analysis

It shows how much debt the company used to finance its assets. If a company is almost entirely financed with debt that means the company might get into serious trouble when emergencies arise like a raise in interest.

The three steps every investor should look at:

Things to be aware of

How to calculate debt to asset ratio

Real life example Rainbow

You need the following data to determine debt to asset ratio:

The debt to total assets ratio shows if the company is owned by creditors or shareholders. Or in other words, the total debt in relation to the total amount of assets. It shows how much debt the company used to finance its assets. 

How to use debt to equity ratio

Why do investors use the debt to shareholders equity ratio in their analysis

It shows how much debt the company uses to finance their operations. Shareholders equity is whats left over when you subtract total liabilities from total assets. It's another way to meassure how much of Rainbow is financed with debt or own resources.

The three steps every investor should look at:

Things to be aware of

How to calculate debt to equity ratio

Real life example Rainbow

You need the following data to determine equity ratio:

Debt to equity measures the total debt versus the total shareholders equity. While the total debts to total assets ratio uses total assets, the debt to equity ratio looks at the total equity of shareholders. Where equity of shareholders are:

You can find the shareholders' equity in the balance sheet. A ratio between 0,5 and 1,5 is preferred. If the ratio is above 1.5,  that would indicate creditors have significantly more stake (debt) in the company than the shareholders. In other words, the company is using a lot of debt to finance their operations.

Not all debt is equally risky. Meaning you can adjust the ratio by including or excluding certain amounts of debt. Short term debts are less risky because they have to be paid back within one year anyway. It’s much easier to plan one year ahead versus five or ten years.

Indicates if the company’s shares are under or overvalued. 

How to use PE ratio

Why do investors use PE ratio in their analysis

The PE ratio tells investors the current sentiment in the market for that company. As with every stock, the stock price never shows the real valuation of a company but rather how the market thinks how much the stock is worth. 

In other words, the current stock price also incorporates any future earnings or business opportunities in the future. The best example is the stock market crash in 2000. The PE ratio for any internet based company was going through the roof. Only based on the general assumption the internet and all associated businesses would thrive in the future. But this was based on nothing. A business still needs a good product or service to be able to survive. Instead, every investor bought any stock which did something related to the internet. Result: huge market crash.

Many investors were willing to pay premium prices and that was causing the PE ratio to rise. A high PE ratio is a warning sign that investors might be overvaluing a stock based on future earnings.

The three steps every investor should look at:

Things to be aware of

How to calculate PE ratio

Real life example Rainbow

You need the following data to determine the PE ratio:

The PE ratio is a very commonly used ratio to determine the value of a company by comparing the current stock price relative to its earnings per share (EPS). Before we can calculate the PE ratio we need to know the EPS. EPS is calculated as follows:

* The net profit minus preferred dividends can be found in the incomestatement as netIncomeApplicableToCommonShares.

The PE value helps investors to determine if the current stock price is under or overvalued. It also projects future growth.

In general, a higher PE ratio means that investors predict higher future growth. If the PE ratio is too high, then investors expect way too much future growth the company can never fulfil. This is most likely to happen in faster moving companies like tech companies or automobile companies like Tesla. These are hot and booming markets where investors expect much future growth driven by new technology (electric cars). When looking at the current MRQ (most recent quarter) PE ratio of Tesla ( jan. 2021) it's about 247 while the average in the industry is only 6. That might be a clue that Tesla is trading for way too high prices compared to their current assets and is more based on future growth.

The book value of Rainbow is what remains when you subtract total liabilities from total assets. This can also become negative which means Rainbow has more debts than assets.

The price to book ratio shows the investor if the stock is under or overvalued. A high price to book ratio means that the investor is paying more for a share than Rainbow has in total assets. 

How to use PB ratio

Why do investors use PB ratio in their analysis

Helps investors to determine if the current stock price is under or overvalued. A low PB ratio means the company’s stock is trading for less than the leftover of total assets - total liabilities. PB ratios can also turn negative which means the company might be in serious financial trouble. In other words, the company has more liabilities than assets. 

The three steps every investor should look at:

Things to be aware of

How to calculate price to book ratio

Real life example Rainbow

You need the following data to determine Price to book ratio:

Calculate the book value:

Calculate book value per share:

Calculate Price to book ratio:

* Note: some calculations might be missing in the above example (step 1 and 2) but the outcome is always visible and correct. That's because the PB ratio is calculated seperately.

The price to book ratio is another way to determine if a stock is under or overvalued. The PB ratio is used to compare the current stock price to its book value. In other words, the PB ratio is used to compare all the assets minus liabilities in relation to the stock price.

If the PB ratio is greater than 1 that means the stock is trading for a higher price than the intrinsic value of the company. Meaning, you pay more than what the company is worth. Although future growth is hard to measure. A higher PB ratio than 1 also means that you are last in line (shareholders get paid last when a company defaults) when the company goes bankrupt for whatever reason. 

Book value is limited for companies that offer services because there are not many tangible assets on the balance sheet compared to large manufacturing companies. It also does not take brand names, patents and other things in consideration.