A firm’s financial statements are analyzed to help determine whether the firm’s underlying stock is over- or under-valued. Ratios are used to express relationships of statement items and compared to benchmarks or peers.
The ratios are grouped according to the aspect which is being measured. The groups are liquidity, activity, profitability and leverage. After the ratios are calculated, the y are used to value the firm’s share price.
Ratio Analysis
Ratios are probably the most frequently used tool to analyze a company because they are readily understood and can be computed with ease. In addition, the information is easy to obtain and used by investors and firm’s management.
The ratios are used to perceive trends in a time series or comparing peers in cross sectional analysis. Certain ratios are more relevant to certain industries than others. The financial and utility sectors use different ratio sets than other sectors.
One ratio by itself doesn’t tell you much but several ratios will give you a good idea on strengths and weaknesses. Rarely, all the ratios show the same general tendency. Ratio analysis is one of the ways SCM measures management quality.
Liquidity Ratios
Liquidity is the ease in which a firm can convert their assets to cash. A highly liquid firm can pay their bills with loss. Liquidity ratios are useful to creditors who are concerned about getting paid on a timely basis.
The most liquid assets are measured with current ratio. It is calculated by dividing the current assets by the current liabilities. In most industries, it is desirable to have more current assets than liabilities but this rule of thumb doesn’t apply to all.
The quick ratio factors out inventory and is a key measure of working capital. This capital is easier to obtain than having to manufacture goods from stock of raw materials. Taken together, these ratios are helpful in analyzing firms with large inventories.
Activity Ratios
Activity ratios indicate what rate the firm is turning its inventory and accounts receivable into cash. High turnover signals it is better position to handle liabilities but does not necessarily indicate maximizing profitability.
Inventory turnover is calculated by dividing Sales by average inventory for a given period. Higher turnover reduces financing costs. Alternatively cost of goods sold can replace sales which maybe needed to focus on the ease of covering costs.
Average collection period and receivable turnover are ways of measuring management effectiveness. It is difficult for investors to obtain some of these data points because they are only available on a annual basis and could mislead a firm’s seasonal sales, sporadic sales or any growth in inventory.
Profitability Ratios
The amount a firm earns is most important to investors. Earnings accrue to shareholders and fuel dividends. Retained earnings represent additional investment of the corporation. Profitability ratios are a set of ratios which pertain to the firm’s ability to grow earnings and pay dividends.
They measure earnings relative to some base such as sales assets and or equity. The gross margin is cost of goods sold subtracted from revenues divided by revenues It only looks at the core business and ignores how the firm is financed.
The net margin takes into consideration everything: taxes, depreciation and interest paid. The return on assets ratio shows how well management is utilizing their assets. Return on equity shows how profitable they are relative to the shareholder’s stake.
Leverage Ratios
Financial leverage ratios indicate how the firm can magnify the shareholder’s investment using debt. Because debt financing can have a large impact on the firm, these ratios are extremely valuable in analyzing the risk of the firm’s financial position.
The most common leverage ratios are debt to equity and debt to total assets. The former is figured by dividing debt by equity. The latter is calculated by dividing debt by total assets. Either is acceptable.
These measures are aggregates and don’t distinguish short-term and long-term. Theory suggests there is an optimal combination of debt and equity financing which maximizes the value of the firm. Investors will invest their funds with a large amount of debt to leverage their equity.
Ratio Analysis
An investor does not need a ton of ratios to get a good idea of a firm’s financial condition. Their area of focus differs from a creditor in that a creditor is more worried about the liquidity to get paid.
Performance is more relevant to investors with measures such as distribution of earnings, growth in earnings and market’s valuation of the stock. Also important is the capacity of the firm to grow by internally generated funds.
Interpretation of the ratios is critical to decision making. If a ratio doesn’t match a benchmark or the firms being compared have slightly different businesses, subjective judgement is key.
Ratios and Valuation
There can be variations in ratios from year to year or things can remain stable. If there are deviations from benchmarks or from peers, the investor must ask why. It might be a nonrecurring item and can be ignored or a trend with negative consequences.
The ratios may not help with the investment decision due they being based on historical data and the not indicative of the future. Even if past performance is repeated, the investor has to have an idea of the firm’s worth.
Visit these topics for further detail or return to the Investment Basics page:
- Basics Introduction
- Security Markets
- Information Sources
- Risk and Portfolio Theory
- Investment Companies
- Stock Valuation
- Macroeconomic Environment
- Statement Analysis
- Bond Market
- Foreign Securities
The material presented on this page and Investment Basics pages were adapted from Dave’s lecture notes for the Investments for Professionals course taught at UCLA 1998-2005 and three decades of practical experience. See our Site Credits page for reference sources.
