Financial Ratio Analysis
The valuation ratios are covered in the valuation chapter. Valuation ratios help you determine what the company is worth. The ratios described in this section are the ones you will use to evaluate the financial health and earnings power of the company.
There are two broad categories of financial ratios: Profitability Ratios and Financial Health Ratios. Profitability Ratios are used to show how well the company can use its funds to generate profits. Financial Health Ratios are used to show how likely the company will be to survive if it runs into economic trouble.
1. Profitability Ratios
There is a wide range of profitability ratios with a varying amount of flexibility, but they are all used to measure the same basic thing. They are all used to measure how much money the company can make compared to how much it has or how much it spends.
For profitability, higher is almost always better.
i. Profit Margin
There are a number of different profit margins to analyze, each with a different purpose: Gross Profit Margin, Operating Profit Margin, and Net Profit Margin. In general, each of these ratios tells you how much money the company is making for each dollar of sales. In other words, it adjusts the profit numbers for the size of the company. It is useful for measuring how the company performs compared to other companies in the same industry and comparing how the company has progressed over time.
Gross Profit Margin: Gross profit margin uses the gross profit numbers, which are based only on the cost of goods sold. This number is considered largely outside of management’s control and is based on the type of industry that the company operates in. For example, manufacturing firms have relatively low gross profit margins, and technology companies have relatively high gross profit margins. When you use this ratio, it should be compared with other companies in the same industry.
Operating Profit Margin: Operating profit margin uses the company’s operating profits as its point of reference. Operating profit is often considered to be directly tied to the quality of management’s decisions, but this is not always the case. When operating profit margin is declining, it can be either because of increased competition (fewer sales) or management losing control of costs. If the cause is from something outside of the company’s control, other companies in the same industry should be having similar declines in operating profit margins.
Net Profit Margin: The net profit margin is the broadest way to measure profit margins. It is not considered to be as accurate as the other profit margins, but it should give similar results. The same comparisons can be made, but it will not show how well the company is managing different categories of costs.
ii. Return On Equity (ROE)
Return on Equity (ROE) is one of the most widely used ratios. It can be compared with any other company from any other industry, and can also be used to track changes in the company’s profitability. For this number, higher is almost always better.
You will usually want to see an ROE number that is at least higher than the return on treasury bonds, but the average long-term ROE for the S&P is between 10% and 15%. If you are looking for exceptionally profitable companies, an ROE of 20% or above is a very good sign. However, you might want to compare ROE to others in the same industry to see if there is room for improvement.
The main disadvantage to using ROE is that it does not account for the amount of debt the company holds. Higher amounts of debt will create artificially high ROE numbers. ROE is also a better indicator if you only include the operating income.
iii. Return on Assets (ROA) and Return on Capital (ROC)
Return on Assets is considered a more reliable indicator than ROE because it uses the total amount of debt and equity instead of just equity. However, unlike the ROE numbers, ROA comparisons are only relevant for companies within the same industry. Industries that utilize high amounts of borrowed money, such as the financial sector or utility sector, have lower ROA.
Return on Capital is one step more stringent than ROA. This number measures how well the company is investing its money. Like ROA, it uses the company’s total capital, but it only includes the money that the company keeps to reinvest in the business. Dividends are taken out.
The comparisons for ROC are the same ones used for ROA, but the weaknesses are also similar. Like ROA, ROC does not tell you exactly where the returns are being generated; only what the returns are.
2. Financial Health Ratios
Financial Health Ratios help you see how well the company will do during difficult economic conditions. The less robust a company’s health ratios, the more vulnerable the company is.
Financial Health Ratios are either debt-based (liabilities) or liquidity-based (cash). Liquidity-based ratios usually focus on short-term health and debt-based ratios focus on long-term health. The overall picture is meant to answer the question of how well the company can pay its debts. In most cases, the long-term indicators are more important.
i. Liquidity-Based Ratios
Current Ratio: The current ratio is the most commonly used liquidity-based ratio. It tells you how easily the company could pay its debts if they all came due at once. It is calculated by taking current assets and dividing them by current liabilities. In theory, you want this number to be at least 1, but the number can be misleading. If the current assets are not made up of cash, then they will not actually be available to pay off debts.
Quick Ratio: The quick ratio (also known as the acid-test ratio) improves the current ratio by removing inventory from the equation because inventory is more difficult to turn into cash. Like the current ratio, you would like to see this number be above 1. However, the ratio still includes accounts receivable, which are not always easy to convert into cash.
Cash Conversion Cycle (CCC): This is considered the most reliable liquidity ratio because it measures the time (in days) that a company’s cash is tied up in production and sales. It gives you an idea of how fast the company is building its cash position. It is the most conservative measure, but it also takes the longest time to calculate.
The CCC is calculated as: CCC = DIO + DSO - DPO
DIO = Days Inventory Outstanding
DSO = Days Sales Outstanding
DPO = Days Payables Outstanding
To find DIO: Divide the cost of sales by 365 to get the cost of sales per day (from the income statement). Find the average inventory (from the balance sheet). Then divide average inventory by cost of sales per day.
To find DSO: Divide net sales by 365 to get net sales per day (from the income statement). Find the average accounts receivable (from the balance sheet). Then divide average accounts receivable by sales per day.
To find DPO: Divide the cost of sales by 365 to get the cost of sales per day (from the income statement). Find the average accounts payable (from the balance sheet). Then divide average accounts payable by the cost of sales per day.
In general, there is no hard rule about the CCC, but the shorter the cycle, the better. A company with a high or increasing CCC may face future cash flow problems. The relevant comparison for the CCC is with other companies in the same industry.
ii. Debt Based Ratios
Debt to Equity Ratio: The Debt to Equity Ratio is the most commonly used debt-based ratio. It tells you how much the company is using debt to generate returns. This is often tied to its industry. Technology firms often have a debt to equity ratio of less than 0.5, while utilities and manufacturers often have a ratio of about 1 or 2, and financial firms sometimes have ratios of 5 or higher. The higher the number, the more vulnerable the company will be to bankruptcy.
This ratio is most useful when it is evaluated in relation to ROE. Since high levels of debt can inflate ROE numbers, two companies can have the same ROE number, but the company with a lower D/E ratio is achieving those returns with less leverage.
The best comparisons for D/E are for companies within the same industry. In general, lower D/E is better, but for most firms, a D/E of 1 is still considered a safe benchmark.
Interest Coverage Ratio: Interest rate coverage is used to show how easily the company can pay the interest on its debts. Regardless of the amount of debt a company holds, if it does not earn enough money to pay the interest on those debts, it will not survive. This number is calculated by dividing the earnings before interest and taxes (EBIT) by the interest expense.
For interest coverage, any number above 2 is good. If the number is between 1 and 2, you will want to do more research on the company’s earnings power. Any number below 1 is a red flag.
A good way to evaluate this number is to track how it changes over 3 or 4 years. If the number is not already above 2, an increasing interest coverage ratio is a good sign.
Cash Flow to Debt Ratio: The cash flow to debt ratio is a variation of the previous debt-based ratios. It is calculated by taking operating cash flow and dividing it by total debt. The purpose is to see how much of the company’s debt could be covered by cash flow if the debts were all due at once.
This number is usually expressed as a percentage (the amount of cash flow as a percentage of total debt). A good absolute benchmark is 66%, but the ideal number will vary based on industry and economic conditions. Capital intensive industries such as construction or manufacturing will have the lower cash flow to debt ratios, and economic recessions will cause the number for every company to go down.
The best comparisons will come with companies in the same industry and by tracking the same company over time. For this number, higher is better.