Penny stocks should be avoided by investors who are afraid of losing money. However, this does not imply that penny stocks are invariably losing investments. A penny stock can sometimes hit the jackpot.

Penny companies like Ford Motor Company (F) and American Airlines Group Inc. (AAL) are trading at the high end of the blue-chip spectrum. Pencil-stock investors who aren't afraid of volatility and lax regulation can use important financial ratios to reduce risk and, in some cases, make a profit.

What Are Penny Stocks?

The Securities and Exchange Commission of the United States defines penny stocks as securities issued by corporations with a market capitalization of $250 million or less.

The $1 per share cutoff threshold is used by some experts. They are traded on the OTC market (over-the-counter). While traditional exchanges like Nasdaq and the New York Stock Exchange have minimum standards for companies to remain on the market, over-the-counter platforms do not. These may be businesses with no prior track record, a lack of predictability in sales or earnings, shaky management, or limited information about how they operate at this point. While some penny stock firms are focused on tried-and-true industries, others are launching new products or services that have yet to be put to the test.

Penny stocks are intriguing because of their low price. For investors, finding the next American Airlines or Ford Motor Company is a dream come true. These cheap share prices, however, often entail huge financial commitments, which is a drawback. Penny stocks are risky due to their high volatility and lack of liquidity. Investors may not be able to get rid of their shares in time if stock prices soar. Due to the speculative nature of penny stocks, rigorous study and analysis must be conducted before investing.

How to Reduce the Risks of Penny Stocks

Selecting OTCQX-listed companies can help lessen the risk of penny stock investments because of the The OTC market has a lack of transparency. The OTCQX has more strict financial standards for companies that are listed on the OTCQX exchange.

In order to comply with US securities laws, the OTCQB and OTC Pink markets must follow more stringent requirements than the remaining two OTC market tiers. To be on the safe side, investors should steer clear of OTC Pink businesses that are not regulated by the SEC.

Fundamental analysis can help you choose a good penny stock investment by identifying and evaluating the company's strengths and weaknesses. Be aware, however, that with penny stocks, the lack of timely and meaningful public information may make solid fundamental analysis difficult to do.

Financial Ratios

We may use some of the same analytical approaches we use for larger companies to decide whether a particular penny stock is worth our investing dollars if there is appropriate financial disclosure. Because so much of the penny stock's value is built on future expectations of success, strong figures and a good trend on the balance sheet, income statement, and cash flow statement are critical.

First, investors should look at liquidity ratios (such as current, quick, cash, and operating cash flow ratios) when evaluating penny stock investments. Stocks in penny companies are frequently unable to satisfy their short-term obligations within a specified time limit. For example, low liquidity ratios indicate that an organization is having difficulty staying afloat or advancing in its operations.

In addition to financial ratios, leverage ratios are an important subgroup of ratios. As with liquidity ratios, their primary focus is on how well a corporation can meet its outstanding obligations in the short term. We are concerned about the long-term debt in this case. The debt-to-equity and interest-coverage ratios are two of the essential leverage measures.

These financial ratios can then be compared to past reporting periods or forecasted ratios for the future once they have been calculated. These ratios can also be compared to those of the company's direct competitors and the broader market to acquire valuable information about the company's performance and value.

The Bottom Line

Penny stock prices fluctuate largely on market demand rather than company fundamentals or the balance sheet, which is often the case. The proper intrinsic value of a penny stock is often impossible to determine using mathematical means. Their prices are highly volatile and reflect their perceived value rather than their real worth. The level of company disclosure is at best weak and at worst nonexistent. To trade on the OTCQX, companies must provide regular and accurate disclosures about its fundamentals. For penny stock investors, the OTCQX market and financial ratio research are the best ways to minimize risk.