Key Financial Ratios to Analyze Tech Companies

The technology sector is an industry of companies (and related stocks) that conduct research and development and/or distribute technologically-based goods, services, and products. This sector includes businesses that manufacture electronics, create software; and build, market, and sell computers and products related to information technology.

Technology companies are unique in that they often carry little to no inventory; they are commonly not profitable and might not earn revenues. Additionally, many technology companies take on large venture capital investments or issue large amounts of debt to fund research and development.

The strategy of technology companies is generally different from other companies in that many seek to be acquired rather than generate profits. As a result, there are key financial ratios used when analyzing a technology company.

Liquidity Ratios

Liquidity ratios provide information about a company's ability to meet short-term obligations. Since many technology companies do not make a profit or even generate revenue, it is extremely important to analyze how well a technology company can meet its short-term financial obligations.

Current Ratio

This ratio is the most common liquidity ratio for measuring a company's ability to pay its short-term financial obligations. It is also the least conservative of the liquidity ratios. In the technology industry, it is important to have a high current ratio since the business normally needs to fund all of its operations from current assets, such as the cash received from investors.

Current ratio = (current assets / current liabilities)

Cash Ratio

The cash ratio is the most conservative of all the liquidity ratios, making it the hardest evaluator of whether a company can meet its short-term obligations. This is the most important liquidity ratio for a technology company because the company normally only has cash and not other current assets, such as inventory, to meet its current obligations.

Cash ratio = (cash + marketable securities) / current liabilities)

Additionally, technology companies may have a large number of marketable securities through acquisitions and investments, and these securities should be included in the liquidity calculations.

Financial Leverage Ratios

Opposite of liquidity ratios, financial leverage ratios measure the long-term solvency of a company. These types of ratios take into account long-term debt and any equity investments, both of which highly impact technology companies.

Debt-to-Equity Ratio

The debt-to-equity ratio is extremely important for the analysis of technology companies. This is because technology companies make large amounts of investments in other technology companies and take on investments and debt from other organizations to fund product development.

Debt-to-equity ratio = (total debt) / (total equity)

When a technology company decides to acquire another company or fund necessary research and development, it normally does so through outside investments or by issuing debt. When a stakeholder analyzes a technology company, it is important to look at the amount of debt the company has issued. If this ratio is too high, it could mean the company will become insolvent before turning a profit and paying back the debt.

Profitability Ratios

While many technology companies are not initially profitable, even large ones like Amazon, it is necessary to look at their margins; other ratios, such as the gross profit margin, are a good indicator of future profitability even if there are no current operating profits.

Gross Profit Margin

Gross profit margin = (Net sales - cost of goods sold) / Net sales

This profit margin measures the gross profit earned on sales. It is only applicable if a technology company is generating revenue, but a high gross profit margin is a signal that once the company scales, it could become very profitable. A low gross profit margin is a signal the company is unable to become profitable.