Deciphering financial statements for non-financial professionals - Part 7

January 02, 2015

The Rationale of Ratios 

This seventh post in my Deciphering Financial Statements for Non-financial Professionals series provides a summary of the application of ratios and other tools to draw conclusions from a company’s financial statements to understand its financial health and form expectations for the future. In this series of posts, I provide insight into financial reporting and related topics geared toward non-financial professionals who are required to understand financial statements as part of their professional roles. I encourage you to also read the other installments in the series, both past and future, particularly the introduction as that post establishes the series and includes a number of resources you may find useful. 

In posts 1 through 6, I’ve provided some essential information to provide you with an understanding of the major components of a company’s financial statements. Now it’s time to pull it all together. The key to drawing informed conclusions from a company’s financial statements is to look for trends and correlations. A simple method to derive such information is through the application of ratios. A ratio on its own doesn’t generally provide much useful information. It is necessary to compare ratio results at numerous points in time to reveal trends in the company’s operations. 

Further insight can be gained by comparing ratio results to those calculated on peer companies’ financial results. Identifying a handful of relevant peer companies may be a time consuming exercise at the outset, but it’s worth the effort in benchmarking against competitors and determining whether trends in a company’s operations are from internal causes or external threats affecting the entire industry. Financial statements for Canadian public companies can be accessed via SEDAR for purposes of peer company comparisons. 

1: Liquidity Analysis

A core consideration for any business is maintaining liquidity. A seasoned, successful business may have little need to worry about cash crunches; however careful monitoring to identify and remediate negative liquidity trends early is a prudent strategy for any company.

Working Capital = current assets – current liabilities

The net working capital balance is an indicator of whether the company is able to pay down its liabilities in the normal course of business. If the current assets equal its current liabilities, the company has no working capital and essentially has no cash reserves to fund ongoing operations. The more working capital a company has available, the better.

Current Ratio = current assets / current liabilities

This ratio reveals how much working capital a company has available to carry on operations in the short term. A ratio of 1:1 means there is essentially no working capital since all of the company’s current assets will be required simply to pay down its current liabilities. That being the case, a higher ratio such as 2:1 or 3:1 will better provide you with that warm, fuzzy feeling. A lower ratio such as 0.5:1 may signal challenging times in the company’s immediate future.

Quick Ratio = (current assets – inventory) / current liabilities

This is similar to the current ratio above except that it pares down only the assets that can be readily liquidated, providing an indication of how quickly the company could pay down its liabilities, should that be necessary. This ratio may be useful where a company is faced with a cash shortage and is deciding whether bridge financing is necessary.
2: Profitability Analysis

Everyone’s concerned about profitability – and for good reason. Profitable operations allow for growth and healthy returns for stakeholders. The following ratios allow you to evaluate trends in a company’s profitability and to ask informed questions when operating results are not as expected.

Gross Margin = gross profit / net sales

This ratio, calculated as a percentage, reveals how profitable a company’s products are in isolation. Margins vary, but the rule of thumb here is the higher, the better. Generally, the higher the margin, the less activity the Company is required to have in order to make a profit.

Earnings per Share = net income after tax / weighted average number of common shares

This is an important enough ratio that it’s presented on the face of the statement of operations, usually located at the bottom of that page. It’s a simple way to determine how much the company earned in comparison to the number of shares outstanding, which nicely factors in shareholder dilution.

Return on Assets = net income / average total assets
This ratio reveals how effective the company is at generating profit from its assets, which is of particular interest for companies that are asset intensive, such as manufacturing entities. This can be calculated on either a before or after tax basis, although a before tax basis may be preferred as it excludes the benefit of tax planning that may not impact all periods evenly. The higher the percentage, the better: best to compare to industry peers over time to draw meaningful conclusions.

Return on Shareholders’ Equity = net income / average shareholders’ equity

Similar to return on assets, this ratio reveals the percentage of income earned by the company on the investment provided to it by its shareholders during the year and can also be calculated on either a before or after tax basis.

EBITDA: earnings before interest, taxes, depreciation and amortization

Okay, so this isn’t a ratio but I thought it warranted discussion as many people look to EBITDA as a raw indicator of a company’s profitability. There is some variance in practice in the calculation of EBITDA, but it’s generally what it sounds like.
3: Activity Analysis

Activity ratios provide you with a glimpse into how well a company’s management converts its resources into cash. A seemingly profitable operation can suffer from cash flow problems on account of inefficient financial management.

Accounts Receivable Turnover = sales / average accounts receivable

This gives you an idea of how often a company turns over accounts receivable each year – essentially how quickly cash from credit sales is collected. There’s no specific rule of thumb for what is a ‘good’ ratio here, as this will vary depending on the nature of the industry and the company’s specific operations, but generally the more receivables turns over during the year, the better. A weakness of this ratio is that it doesn’t reveal specific receivable balances that may be delinquent or otherwise slow to pay. That being the case it’s good practice to review a detailed aged accounts receivable listing in connection with this ratio if you have access to such data.

Inventory Turnover = cost of sales / average inventory

Similar to accounts receivable turnover, this ratio reveals how quickly a company turns over its inventory, with a high turnover rate being better than a low one. Again, the weakness in this ratio is in the details: it may not reveal where certain inventory items are slow to move so it’s important to dig into an aged inventory listing, particularly if the turnover rate declines from pervious periods.
4: Capital Structure Analysis

There are many strategies to fund a company’s growth. Capital structure ratios provide you with insight into a company’s capital strategy and revealing when that strategy may be changing.

Debt to Equity = total liabilities / total shareholders’ equity

This ratio tells you how much of the company’s assets are financed through debt versus through the company’s own historical operations or cash infusions by its shareholders. There are many strategies to fund a company’s growth affecting this ratio’s results, but generally you want to see a lower ratio (ie: 1:2 instead of 2:1) as debt can be a costly method of financing.

Times Interest Earned = net income before interest and tax / interest expense

This is of particular interest for companies that fund their operations largely through debt as it provides an indication of a company’s ability to service its loans. The higher the ratio, the better, and if it’s getting close to 1:1, the company may be struggling. It’s important to note that this isn’t a cash flow measure and so this ratio is a slightly blunt instrument in that respect.
5: Capital Market Analysis

Investors often use capital market analysis ratios to determine whether they should invest, or continue to invest, in a company. They can also be useful tools to apply internally to understand how the market may perceive the company.

Price Earnings Ratio = market price per common share / earnings per share

A high price earnings ratio, often shortened to just “PE ratio”, may indicate that investors are expecting earnings growth to be higher in the future than during the present in comparison to peer companies. There is no rule of thumb for a good PE ratio. Instead, it’s key that a company’s PE ratio be compared to its industry peers and over a period of time.

Market to Book Ratio = market price per common share / (book value of common shares / number of common shares issued and outstanding)

A low market to book ratio may mean that the stock of the company is undervalued, since it’s trading for less than what the company issued the shares for. Where such a result is found, it’s prudent to research carefully to understand the reason for the low share price prior to making an investment decision.

Dividend Yield = annual dividends per common share / market price per common share

This ratio essentially calculates the return on investment, excluding capital gains considerations, which is of particular interest if you plan to hold the stock for a long time. If you’re looking for cash flow, this may be a key consideration in which stock to buy.

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