Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you specific investment advice that will help you develop a successful approach to investing. Each Investor Toolkit update gives you a fundamental tip and shows you how you can put it into practice right away.

Today’s tip: “Financial ratios will tell you a lot about a stock—but look closer and you may get an even clearer picture.”

One key to successful investment analysis is to put all the important information you know about an investment into perspective.

A company’s new invention may be a marvel, but how does it compare to the competition? The new project sounds impressive, but how much impact will it really have on profit? The debt sounds high—will the company be able to keep up its agreed-upon interest and principal repayments?

Investors intuitively understand this rule, but they often find it hard to apply. You can tackle the job with financial ratios, but the answers you get can be ambiguous if not misleading. You need to look a little deeper before you buy stocks.

For instance, if a company takes on a large debt, you can test how big a burden it will be by calculating its interest coverage. To do that, you divide its yearly profit by its yearly interest costs. The higher the number, the better.

If its profit is 10 times bigger than its interest cost, it can suffer a big earnings downturn and still keep up its interest payments. If its profit is 1.0 times its interest cost – equal to its interest costs, in other words – it has no margin of safety. Any earnings downturn (or increase in interest cost) will leave it short of cash to cover its interest.

But things are never quite so simple. The company’s latest earnings may reflect unusually favourable or unfavourable conditions. This can make the company look safer or riskier than it really is. In addition, the company may put the funds it borrowed to immediate profitable use, increasing its earnings and its ability to pay interest. It may plan to sell assets to reduce debt, or cut costs to increase earnings.

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Look at what the market thinks a company is worth

The debt/equity ratio is another way to assess the company’s financial condition. The conventional idea used to be that a debt/equity ratio should be less than 1.0; this is, debt should be less than equity. But the conventional definition of equity only includes capital invested in a company, plus earnings that were retained in the business rather than paid out.

For many companies today, this is not a particularly accurate way to look at things. That’s because the company’s main value is in assets that it built out of a tiny asset base. In cases like this, it may make more sense to compare a company’s debt to its market capitalization or “market cap”—the value of all stock it has outstanding. Market cap tells you what the market thinks a company is worth. It often makes a lot more sense that the equity value that appears on the company’s books.

There are many ways to try to put the facts about a company into perspective. None are perfect, since all involve a mental balancing act between high and low estimates, history and the future, and faith versus skepticism. Our goal is to put the information in a form that lets us weed out the extremes—excessively over-valued stocks, and those that are suspiciously cheap.

In the long run, investors make most of their profits in investments that offer good value and an attractive long-term outlook.

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What information do you believe you must have about a stock before you can make a confident decision to buy it? Let us know what you think in the comments section below. Click here.

Make sure the numbers on a stock tell the real story. [Tweet this]