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What Is the Acid-Test Ratio?
The acid-test ratio (ATR) is one popular way to calculate a company’s liquidity, or the amount of cash or near-cash assets a company has to deal with immediate expenditures.
In comparing a company’s short-term assets against short-term liabilities, the acid-test ratio shows whether or not a company is well-financed. This ratio is subjective based on industry and the primary fundamentals of certain business models, but is a useful tool for gaining a basic understanding of a company’s liquidity level.
What Is the Acid Test Ratio?
An acid-test ratio (ATR), or quick ratio, is a comparison of a company’s most liquid short-term assets and short-term liabilities to calculate how much money it has to pay for immediate liabilities. In other words, it calculates how well a company can pay for short-term financial obligations with cash or assets that are easy to convert into cash.
The ATR disregards illiquid company financial assets such as real estate and inventory, instead focusing on the company’s ability to pay its current liabilities without needing to sell inventory or secure additional outside funding. This form of fundamental analysis is a more conservative measure than the current ratio, which includes all current assets when accounting for current liabilities.
A higher ATR indicates a company’s better liquidity and financial health, whereas a lower ratio indicates a company is more likely to struggle with paying immediate liabilities such as debts and other expenses. That being said, if a company takes longer to collect accounts receivable than usual or has current liabilities that are due but have no immediate payment needed, the acid-test ratio may not provide an accurate measurement of a company’s financial wellness.
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What Does the Acid-Test Ratio Tell You?
The acid-test ratio shows how financially capable a company is of paying short-term financial expenses. For beginner stock investors, calculating a company’s ATR may be an insightful fundamental analysis to look at a company’s financials.
An acid-test ratio of less than one indicates a company doesn’t hold sufficient liquid assets to cover current short-term liabilities and should be dealt with cautiously. It’s generally held that for most industries, the acid-test ratio should be greater than one.
However, a high ATR is not always best, as it could indicate an excess of idle cash that could otherwise be reinvested, returned to shareholders, or otherwise used productively for the business. For example, some technology companies generate substantial cash flows, which results in above-average acid-test ratios. While this indicates a healthy and productive business, some may advocate that shareholders who invest in the company should receive dividends from the company’s profits.
Recommended: How Do Stock Dividends Work?
If a company’s ATR is significantly lower than the current ratio, this indicates the company’s current assets largely depend on inventory. This isn’t necessarily a negative sign as some business models are inherently inventory-driven, such as retail stores, which typically have low acid-test ratios but aren’t necessarily in poor financial condition.
In such scenarios, it may make sense to consider other metrics such as inventory turnover. While acid-test ratios can vary widely based on industry, comparisons based on acid-test ratios can be more helpful when analyzing peer companies in the same industry.
How to Calculate the Acid-Test Ratio
The acid-test ratio is calculated as follows:
ATR = (Cash + Cash equivalents + Marketable securities + Current accounts receivables) ÷ Total current liabilities
To fully understand the ATR, it’s important to know the significance of each part of the equation:
• Cash and Cash Equivalents: The most liquid current assets on a company’s balance sheets:
◦ Savings accounts
◦ CD with maturity of less than three months
◦ Treasury bills
• Marketable Securities: Liquid financial instruments readily convertible into cash.
• Accounts Receivables: Money owed to the company from providing goods and/or services to customers/clients.
• Current Liabilities: Debts or obligations due within 12 months.
What Does the Numerator Mean in ATR?
The acid-test ratio’s numerator is ultimately a realistic assessment of the company’s liquid assets. This includes cash, cash equivalents, and short-term investments such as marketable securities, treasury bills, and very short-term deposits.
Accounts receivable are generally factored in as well, though there are industry-specific exceptions, such as construction, where accounts receivable may take significantly more time to recover than other industries — which may give the illusion the company’s financial condition is worse than in actuality.
Alternatively, the numerator can be calculated by subtracting illiquid assets, including inventory, from all current assets. This may negatively skew retail businesses’ financial condition because of the amount of inventory they typically hold. Additionally, subtract any other items that appear as assets on a balance sheet if they cannot be used to cover immediate-term liabilities such as prepayments, advances to supplies, and tax-deferred assets.
What Does the Denominator Mean in ATR?
The acid-test ratio’s denominator is composed of all current liabilities, defined as debts and financial obligations, due within 12 months.
Though time is not factored into the acid-test ratio formula, it can be a relevant variable. For example, if a company’s accounts payable are due sooner than its receivables are expected, the ratio may not factor for this time discrepancy that may arise, thus worsening the company’s financial health.
On the other hand, time can also be a benefit if accounts receivable are more frequent and regular than accounts payable, providing more frequent cash infusions to a possible undersupply of short-term assets.
Pros and Cons of the Acid-Test Ratio
When it comes to assessing the usefulness and accuracy of the ATR, there are both pros and cons.
Pros
1. It removes inventory from calculation, providing a more accurate picture of the company’s liquidity position.
2. It removes Bank Overdraft and Cash Credit from current liabilities because they are usually secured by inventory, thus making the ratio more tangible.
3. It’s not handicapped, as there is no need for valuation of inventory.
Cons
1. The ATR is not the sole determinant of a company’s liquidity. It’s commonly paired with other liquidity formulas such as current ratio or cash flow ratio to form a more complete and accurate assessment of a company’s financial condition and liquidity status.
2. ATR disregards inventory in calculating the ratio because inventory isn’t generally considered a liquid asset. However, for businesses that are able to quickly sell their inventory at market price, inventory would qualify as a near-cash asset.
3. It doesn’t provide information regarding time frame and degree of cash flows—fundamental factors in accurately calculating a company’s ability to satisfy its accounts payable when due.
4. It assumes accounts receivable are readily available, which may not be as easy as anticipated.
The Takeaway
The Acid-test ratio is an insightful and relatively accurate analysis of a company’s liquidity status. It’s one of the many methods for analyzing businesses, reviewing business fundamentals and company financials.
By comparing the company’s cash on-hand, near-cash equivalents, and easily convertible short-term assets against its current liabilities, one can surmise how readily prepared a company is to satisfy short-term liabilities. The formula determines how liquid a company is based on a variety of assets and expected cash flows versus expected accounts payable. This ratio, though not designed to be used solely, ultimately determines if a company is well capitalized or under financial strain. For an investor, this can help shine a light on whether or not a company may or may not be a promising investment.
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SoFi Invest® INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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Read moreSep
08
2023
Understanding Diluted EPS
Diluted earnings per share (EPS) is a measure of earnings per share that includes a company’s convertible securities. Convertible, or dilutive, securities are stocks or bonds that could potentially become common shares. Basic earnings per share only considers existing common shares.
Diluted EPS, then, includes in its calculation the factor of convertible bondholders, convertible preferred stockholders, and options holders potentially deciding to turn their securities into common shares. If this were to happen, the number of shares outstanding would increase, with earnings staying the same, resulting in lower earnings per share. Diluted EPS will therefore tend to be lower than basic EPS.
Basic vs. Diluted EPS
What is diluted earnings per share, and how does it differ from basic EPS? Simply put, basic EPS tends to be a higher number than diluted EPS. Basic EPS doesn’t factor in the existence of convertible securities of the impact if they were to be converted into common shares.
Instead, the most basic calculation of earnings per share only takes a company’s net income minus any preferred stock dividends and divides that number by the number of shares outstanding. Convertible securities aren’t factored into the equation.
Because of this, sometimes it’s beneficial to look at a calculation of earnings per share that assumes all possible common shares have been brought into being through existing convertible securities. Doing so gives investors a more realistic view of earnings while assuring no future surprises.
Imagine an investor doing all their homework on the fundamental analysis of a company using only basic earnings per share. EPS, which measures the value that a company delivers to individual shareholders, might look high and the stock pays a good dividend, so the investor might decide the stock is a good one to buy.
But then she learns that the company has been issuing convertible bonds to raise capital and giving new employees stock options to make working there more attractive.
All of a sudden, for some reason, bondholders decide to convert their bonds to common shares, and employees decide to exercise their stock options.
Now this investor’s shares have been diluted, since a bunch of new shares have popped into existence practically overnight. As a result, earnings per share have decreased, and dividends likely have done the same (because the same dividends now have to be paid out to additional shareholders).
If our imaginary investor had used diluted EPS in her calculations, she could have prepared for this kind of scenario at some point. But because this make-believe company created the potential for its stock to be diluted by issuing convertible securities, basic EPS did not provide the full picture.
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How to Calculate Diluted EPS
The formula for diluted EPS is a company’s net income minus any preferred stock dividends, divided by the company’s average outstanding shares minus its dilutive shares. Or:
Diluted EPS = (Net Income – Preferred Stock Dividends)/(Average Outstanding Shares – Dilutive Shares)
The diluted EPS formula is calculating the amount of earnings per share there would be if dilutive shares were to become common shares. The formula is exactly the same as that of calculating basic EPS, but with one important extra step – adding the number of dilutive shares to the number of average outstanding shares (in the bottom half of the equation).
The sum of both existing common shares and the possible dilutive shares creates a larger number on the bottom half of the equation, while the top half remains the same.
Therefore, diluted EPS tends to be lower than basic EPS, as the company’s net income (minus preferred stock dividends) is being divided by a larger number of shares.
For example, let’s say a company makes $1,000,000 in net income and pays no dividend. There are 800,000 common shares outstanding, 100,000 call options, and 100,000 convertible preferred shares.
The diluted EPS formula would yield a result of $1.00 per share in this example, as we would be dividing 1,000,000 dollars in net income by 1,000,000 total potential shares.
Basic EPS, on the other hand, would be calculated as $1,000,000 divided by the 800,000 current shares, yielding a result of $1.25 per share.
While it’s not difficult to calculate EPS and diluted EPS, many companies share the figures with investors in their earnings reports.
Recommended: What You Should Know About Earnings Calls
Why Is Diluted EPS Important?
Diluted EPS reveals what a company’s earnings per share could look like if holders of convertible securities were to decide to exercise their right to hold common shares, and it’s an important consideration during an investor’s analysis of a stock.
Since companies often issue convertible securities like stock options, convertible bonds, convertible preferred shares, a company’s earnings per share could appear higher than reality when not factoring in the potential for dilution.
Convertible securities might be held by people inside or outside of the company, and they may not be turned into shares anytime soon. But what happens when everyone decides to turn in their convertible securities for shares?
For example, if a company’s stock were to rise in price suddenly, and the company had paid several of its employees bonuses in the form of stock options, those employees might choose to exercise those options.
Now there are more common shares than before, but earnings have not increased. Therefore, in a theoretical example like this, earnings per share will have decreased.
A company issuing employee stock options isn’t always a negative thing, however. If the options keep high-quality employees, the result could be positive for the company over the long run. Using options also reduces expenses that come from paying employee salaries, which could free up capital to help the company grow.
Diluted EPS provides a more conservative earnings per share number since it shows what EPS would be in the event of more new shares coming into existence. Basic EPS could appear to be deceivingly high because it doesn’t calculate for this possibility, so it could be a less reliable indicator of when to buy, sell, or hold a stock.
Of course, there might also be times when diluted EPS is unnecessary. Young companies that are still small and growing might not have had the chance to issue any convertible securities yet, so earnings per share might look the same either way.
The Takeaway
Diluted EPS is a measurement of earnings per share that factors in the potential stock dilution that occurs when convertible securities are converted to common shares. Understanding diluted EPS is important so that investors don’t get caught off guard in the event of new common shares being created through the conversion of securities such as stock options, stock warrants, convertible bonds and convertible preferred shares.
When this happens, earnings per share decline, and those who had only been looking at basic EPS in an attempt to determine the profitability of a company will find they made a miscalculation. In some cases, the difference between basic and diluted EPS might not be that different. If a company hasn’t issued convertible securities, or has issued very few convertible securities, then not much dilution would be possible.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
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SoFi Invest® INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.
SOIN0623014
Read moreSep
07
2023
What Is Buying In Bulk?
Buying in bulk means purchasing large quantities of a single product at a lower cost than you’d usually pay for the item. For example, you might buy a six-pack of shampoo for less than the per-unit price you typically spend on a single bottle. Or you might save big by buying a 10-pound bag of grapes instead of the usual one- or two-pounder.
But, like many things in life, buying in bulk has its pros and cons. For instance, you probably have to shell out more upfront to purchase larger quantities, and you might have trouble storing the items or using them up before their expiration date.
Here, you’ll learn more about this topic, including:
• What is buying in bulk?
• How much can you save by buying in bulk?
• What are the pros and cons of buying in bulk?
• What are tips for bulk shopping?
How Much Is “Bulk”?
How much is bulk doesn’t have an exact answer. There is no specific quantity you need to purchase to have something qualify as bulk buying. Rather, the term means you are buying large quantities of a single item to reap a discount.
That might mean you are buying one jumbo box of cereal (the kind that could feed a cabin full of summer campers) or a 12-pack of regular-size boxes bundled together. You might be buying 36 eggs at a time vs. the usual dozen.
The point is, it’s a larger quantity than what you might find at your local supermarket and at a lower price. And when you buy in bulk and save, you may be helping your overall financial health, too.
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The Pros of Buying in Bulk
A firm financial foundation starts with saving. While the big deal is the potential for saving money on the cost per item, there are other reasons to shop in bulk.
You’re Saving Money
Who isn’t looking for ways to save money daily? If you are wondering, “Does buying in bulk save money?” the answer is usually yes. By buying in bulk, you can likely enjoy a double-digit discount vs. supermarket prices.
You’re Helping the Environment
It can be more socially responsible and environmentally friendly because bulk purchases usually have significantly less packaging per use than smaller purchases have. (Envision a mammoth pickle jar or tub of frosting.)
Ideally, buying in bulk also means you shop less, and that’s less time spent on the road and burning gas.
You May Avoid Impulse Buys
You may rack up additional savings just by being in the store less frequently and having fewer opportunities to pick up things that weren’t on your list. If you’re motivated to save money, avoiding those impulse purchases can be a big plus.
You May Plan and Budget Better
If you’re the organized type who is big on preparing meals in advance, cooking lots of food and freezing it, buying in bulk can make that endeavor easier. That, in turn, can help you take better control of your food budget.
For sure, it’s cost efficient to prepare your family’s favorite pasta dishes and soups and have enough for today and whenever you’re ready for round two or three.
Finding the Price Per Unit
If saving money is important to you, there’s a good chance you want to know exactly how much you are benefiting by buying in bulk. To figure out the real cost you are paying, this is one time you need to do the math. To capitalize on a bulk buy, determine the cost per unit. Sometimes, this number will be listed on the price signage at the store; otherwise, you can use the calculator function on your mobile phone.
• What is a unit? Think measurements like ounces, square feet, grams, and gallons. For example, a bottle of olive oil is not a unit. A fluid ounce of olive oil is. A roll of paper towels is not a unit. A square foot of paper towels is.
• Figure out how many units you are buying. Take the total cost of your purchase and divide that by the number of units to get the price per unit.
• Then compare the unit prices of a few packages of the same product to determine which is the better value.
Ideally, the cost per unit of a bulk buy should be 20% to 35% below what you would normally pay at the supermarket.
Although a supersized item usually has a lower cost per unit than its smaller brethren, crunch the numbers to see.
How Much Can You Save By Buying in Bulk?
No doubt, it can be hard to save money today, and you may wonder whether buying in bulk is worth it. The answer is: It depends. While the amount shoppers save depends on the item, they can anticipate saving around 25% on purchases, according to one recent study across 20 categories of products. Another study found savings of up to 35% at the wholesale clubs vs. supermarkets.
You can also up your savings from buying in bulk by using coupons for those items.
Remember, what’s important isn’t an item’s price but the price per unit.
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3 Tips for Buying in Bulk
When you want to stop spending so much and begin buying in bulk, you need a game plan. It’s a good idea to reach for the familiar and sweeten the deal by looking for familiar items that are also on sale. That will snag you the best prices and help keep your bank account well padded.
1. Stick With What You Know
This is not the time to experiment. If you’re loading your cart with goods, you don’t want to be guessing about whether you’ll love them or not. Go for the family’s beloved items.
Buying in bulk and getting a deal is worthless if nobody wants to eat or use what you buy. That’s money down the drain.
2. Search for Your Favorites on Sale
Don’t want to buy what’s on sale solely because it’s on sale. When trying to cut your grocery bill, the goal is to get what you know and love on sale, not to be overly adventurous. The latter can leave you disappointed, with a few fewer dollars in your pocket to boot.
3. Keep Expiration Dates in Mind
Do check expiration dates when buying in bulk. Items can expire before you get to use them, which is akin to throwing away your hard-earned money. Everything from sunscreen to olive oil can deteriorate when left to sit for long periods because you bought a mega-pack, so shop carefully.
What to Buy in Bulk and What to Avoid
Some products are perfect for stockpiling. While your list will depend on your family, think of items like:
• Paper towels
• Toilet paper
• Tissues
• Detergent
• Dishwashing liquid
• Sponges
• Aluminum foil and plastic wrap
• Toothpaste
• Canned beans and fish
• Frozen foods
• Rice
• Sugar
• Flour
On the flip side, generally, you don’t want to load up on fresh produce unless you are cooking for a crowd, as your family may not be able to eat it all before it wilts or gets moldy.
The Cons of Buying in Bulk
Buying in bulk can work to your advantage, but it’s not without caveats.
Larger Quantities Can Mean Spending More
Paying $40 for $60 worth of lotion may be a good deal, but what if $40 puts a bigger squeeze on your budget than buying individual bottles one at a time, weeks apart? If you use a credit card in order to buy bulk and save, can you pay off the entire bill when it’s due. If you incur interest charges, that will eat into your “savings.”
You’ll Need Storage Space
Keep in mind, too, that you need space to store all that stuff and a car to pile it in to take home. If either of these are issues, buying in bulk may not be ideal for you.
You May Get Bored With Bulk Products
Know thyself…and your family. Maybe you are the person who gets bored quickly, or your kids will beg for some variety after you’ve bought 24 boxes of the same cereal. When you’ve got mega amounts of the same product, be prepared for the “same old, same old” for a long stretch. That’s all the more reason to purchase only what you love, as you may be using it for months.
You May Have to Pay Membership Fees
If you’re going deep into bulk buying, you likely won’t settle only for what you can get in bulk at the grocery store but will want to shop at the warehouse stores like Costco and BJ’s. Consider the annual membership fees that are required.
Costco’s “Gold Star” membership is $60, and the “Executive” level is $120. BJ’s tiers are $55 and $110. Sam’s Club advertises membership fees of $50 and $110.
Will you frequent the store enough to make the fee worthwhile?
Bulk Quantities Can Lead to Overuse
If you have something in abundance, it’s all too easy to be less conscious of how much you’re using. Knowing you have 12 rolls of paper towel stashed away could lead you to use it up more quickly because you know you have backup waiting.
Bigger Quantities Means Spending More Cash
There’s also the issue that if you’re earning a lower income and/or have considerable debt, you may not be able to come up with enough money to purchase bulk products versus their smaller and less expensive single-use versions. One big purchase could blow your weekly budget. If you spend a chunk of money to buy a mega-pack of toilet paper, can you then afford other necessities?
Products May Expire
Buying in bulk can be a fun way to save money, but don’t get so giddy grabbing great buys that you forget important things like expiration dates. Products like bleach and sunscreen may expire in 12 months or less. And certainly food products can expire as well. Getting a gallon of milk for the same price as a half gallon doesn’t do you much good if it sits in your fridge for so long that it goes bad.
Buying in Bulk at Local Grocery Stores vs Wholesale Retailers
You may wonder if you should buy in bulk at your local grocery store vs. at a wholesale retailer (meaning places like Costco or Sam’s Club). It’s true that you may find good deals at your local supermarket (such as buy two cans of tuna and get two for half-price), and coupons can boost your savings.
However, it’s likely that it will be the occasional or somewhat regularly available items that are worth buying in bulk locally. At a wholesale retailer or wholesale club, the business model is to have bulk quantities always available at good prices. That’s the company’s mission and what gives them bargaining power. In other words, their reason for being is to help customers buy bulk and save.
While you may find great deals at your neighborhood grocery store that encourage you to stock up, you are likely to find smart deals in every aisle of a bulk retailer.
The Takeaway
Buying in bulk has its advantages. Getting a good deal can keep you motivated to save money, but you’ll need to be savvy. Buy only what you need and what you can comfortably store and use in a timely fashion.
As with your local supermarket, temptation likely lurks at bulk retailers. It’s best to know how to compare cost per unit and to prepare and follow a shopping list.
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FAQ
How much do you save if you buy in bulk?
While individual savings will vary, one recent study found that you can save up to 25% by buying in bulk.
Why is it cheaper to buy in bulk?
When you buy in bulk, you are purchasing items that involve less manufacturing and packaging time and materials (aka economies of scale). They may also offer savings on marketing and distribution costs. These price breaks are passed along to you when you buy in bulk.
What are 2 downsides of buying in bulk?
Here are two downsides of buying in bulk: It can involve paying more upfront (say, purchasing 12 boxes of cereal vs. one at a time), and the products can expire or otherwise go bad before you can use them up.
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What Investors Should Know About Spread
A spread represents the difference between any two financial metrics. The type of spread depends on the type of security that’s being traded. For example, when trading bonds, the spread can refer to a difference in yields between bonds of varying maturity lengths or quality.
Further, while there are many differences between bonds and stocks — spread is just one of them. With stocks, though, spreadgenerally refers to differences in price. Specifically, it measures the gap between the bid price and the ask price. Understanding what is spread and how it works can help you more effectively shape your investment strategy.
What Is Spread in Finance?
As noted, spread is the difference between two financial measurements. When talking specifically about a stock spread, it is the difference between the bid and ask price.
The bid price is the highest price a buyer will pay to purchase one or more shares of a specific stock. The ask price is the lowest price at which a seller will agree to sell shares of that stock. The spread represents the difference between the bid price and the ask price.
A good way to visualize spread may be to think of buying a home. As a home buyer, you may have a set price that you’re willing to pay for a property, based on what you can afford and what you’ve been pre-approved for by your mortgage lender.
You search for homes and eventually find one that has everything on your wishlist. When you check the listing price, you see that the seller has it priced $10,000 above your budget. In terms of spread, the maximum amount you’re willing to offer for the home represents the bid price, while the seller’s listing price represents the ask.
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What Does Spread Mean?
Aside from stock spread, spread can have a variety of applications and meanings in the financial world.
As mentioned earlier, bond spread typically refers to differences in yield. But if you’re trading futures, the spread can measure the gap between buy and sell positions for a particular commodity. With options trading, it can refer to differences in strike prices when placing call or put options.
Spread can also be used in foreign currency markets or forex (foreign exchange market) trades to represent the difference between the costs for traders and the profits realized by dealers.
With lending, spread is tied to a difference in interest rates. Specifically, it means the difference between a benchmark rate, such as the prime rate, and the rate that’s actually charged to a borrower. So for example, if you’re getting a mortgage there might be a 2% spread, meaning your rate is 2% higher than the benchmark rate.
Bid-Ask Price and Stocks Spread
If you trade stocks online, it’s important to understand how the bid-ask price spread works and how it can affect your investment outcomes. Since spread can help gauge supply and demand for a particular stock, investors can use that information to make informed decisions about trades and increase the odds of getting the best possible price.
Normally, a stock’s ask price is higher than the bid price. How far apart the ask price and bid price are can give you a sense of how the market views a particular security’s worth.
If the bid price and ask price are fairly close together, that suggests that buyers and sellers are more or less in agreement on what a stock is worth. On the other hand, if there’s a wider spread between the bid and ask price, that might signal that buyers and sellers don’t necessarily agree on a stock’s value.
What Influences Stock Spreads?
There are different factors that can affect a stock’s spread, including:
• Supply and demand. Spread can be impacted by the total number of outstanding shares of a particular stock and the amount of interest investors show in that stock.
• Liquidity. Generally, liquidity is a measure of how easily a stock or any other security can be bought and sold or converted to cash. The more liquid an investment is, the closer the bid and ask price may be, since it can be easier to gauge an asset’s worth.
• Trading volume. Trading volume means how many shares of a stock or security are traded on a given day. As with liquidity, the more trading volume a security has, the closer together the bid and ask price are likely to be.
• Volatility. Measuring volatility is a way of gauging price changes and how rapidly a stock’s price moves up or down. When there are wider swings in a stock’s price, i.e. more volatility, the bid-ask price spread can also be wider.
Why Pay Attention to a Stock’s Spread?
Learning to pay attention to a stock’s spread can be helpful for investors in that they may be able to use what they glean from the spread to make better decisions related to their portfolios.
In other words, when you understand how spread works for stocks, you can use that to invest strategically and manage the potential for risk. This means different things whether you are planning to buy, sell, or hold a stock. If you’re selling stocks, that means getting the best bid price; when you’re buying, it means paying the best ask price.
Essentially, the goal is the same as with any other investing strategy: to buy low and sell high.
Difference Between a Tight Spread and a Wide Spread
As discussed, a tight spread could be a signal to investors that buyers and sellers are more or less in agreement that a stock is valued correctly. A wide spread, on the other hand, may signal that there isn’t necessarily a consensus on what the stock’s value should be.
There’s no guarantee, of course, that that inclination is correct, but when looking at tight or wide spreads, it can be yet another useful piece of information to help inform decisions.
Executing Stock Trades Using Spread
If you’re using the bid-ask spread to trade stocks, there are different types of stock orders you might place. Those include:
• Market orders. This is an order to buy or sell a security that’s executed immediately.
• Limit orders. This is an order to buy or sell a security at a certain price or better.
• Stop orders. A stop order, also called a stop-loss order, is an order to buy or sell a security once it hits a certain price. This is called the stop price and once that price is reached, the order is executed.
• Buy stop orders. Buy stop orders are used to execute buy orders only when the market reaches a certain stop price.
• Sell stop orders. A sell stop order is the opposite of a buy stop order. Sell stop orders are executed when the stop price falls below the current market price of a security.
Stop orders can help with limiting losses in your investment portfolio if you’re trading based on bid-ask price spreads. Knowing how to coordinate various types of orders together with stock spreads can help with getting the best possible price as you make trades.
Other Types of Spreads
While we’ve mostly discussed spread as it relates to stocks, there are other types of spreads, too.
Options spreads, for instance, involve buying multiple options contracts with the same underlying asset, but different strike prices or expiration dates.
Under the options spread umbrella are several spreads as well. Box spreads are one example, and they are a type of arbitrage options trading strategy in which traders use some tricks of the trade to reduce their risk as much as possible.
There’s also the debit spread, which is an options trading strategy in which a trader buys and sells an option at the same time — it’s a high-level strategy, and one that may not be suited to investors who are mostly investing in stocks or bonds.
Note, too, that there is something called a credit spread (similar to a debit spread, but its inverse) and that there are some differences traders will need to learn about before deciding to utilize a credit spread vs. debit spread as a part of their strategy. Again, options trading requires a whole new level of market knowledge and know-how, and may not be for all investors.
Investing With SoFi
The more investing terms an investor is familiar with, the better able they’ll be to invest with confidence. Spread is a term that means different things in different situations, but when it comes to stocks, spread is the difference between the bid price and ask price of a given stock. Being able to assess what a spread might mean can help inform individual trading decisions.
As you learn more about stocks, including what is spread and how it works, you can use that knowledge to create a portfolio that reflects your financial needs and goals.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
FAQ
How do you read a stock spread?
A stock spread is the difference between the bid and ask price, so calculating it is a matter of subtracting the bid from the ask price. It’s typically expressed as a percentage.
What is the average spread of a stock?
The average spread of a stock ranges between 13% and 18%, but can vary wildly depending on what types of stocks or market segments are being looked at.
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