If you're new to investing, choosing which companies to invest in can feel overwhelming.

You might wonder, “How do I know if this company is a good investment?”

Fortunately, there are key financial metrics you can use to evaluate a company’s financial health and determine whether it’s worth your investment.

In this article, we’ll walk through five important areas you should look into before making an investment decision.

1. Profitability: Is the Company Making Money?

Profitability is a key factor because, ultimately, you want to invest in a company that is consistently making money. One simple way to check a company's profitability is by looking at its profit margin. Profit margin shows what percentage of revenue the company keeps as profit after covering its expenses.

How to calculate it:
Profit Margin (%) = (Net Profit / Revenue) x 100

For example, if a company earns $1,000 in revenue and its net profit is $200, the profit margin is 20%.

A higher profit margin generally indicates that the company is good at controlling costs and turning sales into profits. However, profit margins can vary between industries, so it’s more meaningful to compare companies within the same sector.

2. Cash Flow: Is the Company Generating Cash?

Cash flow is the lifeblood of any business. Even if a company looks profitable on paper, it could still face trouble if it's not generating enough cash to run its operations. One important figure to check is cash flow from operations—this tells you how much cash the business is making from its day-to-day activities, like selling goods and services.

What to look for:
Ideally, you want to see positive cash flow from operations. This means the company is generating enough money to cover its costs and invest back into the business, without needing external funding (like taking on more debt).

3. Liquidity: Can the Company Meet Its Short-Term Obligations?

Liquidity refers to how easily a company can meet its short-term obligations, like paying suppliers or employees. A common metric for this is the current ratio, which compares a company’s short-term assets (things like cash, inventory, and receivables) to its short-term liabilities (like debts and bills due soon).

How to calculate it:
Current Ratio = Current Assets / Current Liabilities

If the current ratio is greater than 1, it generally means the company has enough assets to cover its short-term liabilities. A ratio below 1 could signal potential financial trouble because the company might struggle to pay off its debts in the near future.

4. Leverage: Is the Company Taking on Too Much Debt?

Debt can be a useful tool for companies to grow, but too much debt can also put a company at risk. The debt-to-equity ratio helps you understand how much of a company’s financing comes from debt versus shareholder equity.

How to calculate it:
Debt-to-Equity Ratio = Total Debt / Shareholders' Equity

A lower debt-to-equity ratio suggests that a company isn’t overly reliant on borrowing, which can be a safer bet for investors. If a company has a high debt-to-equity ratio, it could be taking on excessive risk by using too much borrowed money to fund its operations, which could lead to trouble during economic downturns or rising interest rates.

5. Valuation: Is the Company’s Stock Price Fair?

A common mistake new investors make is deciding whether a company is expensive or cheap based purely on its share price. However, the share price alone doesn't give you enough information about the company's value. To assess whether a stock is overvalued or undervalued, you need to look at the Price-to-Earnings (P/E) Ratio.

The P/E ratio compares the company’s current stock price to its earnings per share (EPS), giving you a clearer picture of how much investors are willing to pay for each dollar of the company’s earnings.

How to calculate it:
P/E Ratio = Current Share Price / Earnings per Share (EPS)

For example, if a company’s share price is $50 and its EPS is $5, the P/E ratio is 10. This means investors are willing to pay 10 times the company’s earnings per share.

What to look for:
A high P/E ratio might indicate that investors expect significant future growth from the company, but it could also suggest that the stock is overvalued. On the other hand, a low P/E ratio might mean the stock is undervalued, or it could indicate that the company’s growth potential is lower compared to its competitors.

Comparing the P/E ratio of a company with other companies in the same industry can help you determine whether the stock is fairly priced.

Conclusion

Before investing in any company, it's crucial to do your homework. By evaluating key financial metrics such as profitability, cash flow, liquidity, leverage, and valuation, you’ll gain a clearer understanding of a company’s financial health and make more informed investment decisions.

Remember, no single metric tells the whole story. It’s important to look at these factors together, along with the company’s competitive position and overall market conditions.

If you’re ready to take your knowledge further and learn how to confidently assess financial statements, I encourage you to watch my limited time webinar replay, “Making Sense of Financial Statements (Even if You’re Not a 'Numbers' Person).” This session will help you feel more comfortable using these tools to guide your investment strategy.

Investing is a journey, and the more you learn, the smarter your decisions will become over time. Happy investing!

5 Financial Metrics to Check Before You Invest in a Company