Examining financial statements helps to reveal trends in line items such as revenue and earnings, however, financial ratios help to illustrate the relationships between specific values on the financial statements and allow for direct comparison with other companies. The value of financial ratios becomes apparent when comparing the values for a given company to sector and industry median values, to major competitors within the industry, and to the company’s past ratios.
In Stock Investor Pro, the Ratios tab presents its information using four categories—profitability, liquidity, debt management, and asset management. Walking through the ratios contained in each of these categories can help you gain an understanding of how to interpret the ratios and gauge the quality of a company:
Long-term investors buy shares of a company with the expectation that the company will produce a growing future stream of cash or earnings. Profits help point to a company’s long-term growth and staying power. When examining the various profitability ratios for a company, it is important to compare them against industry and sector benchmarks in addition to examining their behavior over time. A high margin relative to an industry norm may point to a company with a competitive advantage over its peers. This advantage may range from patent protection to a highly efficient operation that is being fully utilized.
Within Stock Investor, there are five profitability ratios: gross profit margin, operating margin, net profit margin, return on assets, and return on equity.
The gross profit margin of a company reflects its pricing decisions and the costs of the materials necessary to produce its goods or services. It is the ratio of the gross income of a company (sales less cost of goods sold) to its sales for the same period. The greater this margin is and the more stable it is over time, the greater the company’s expected profitability.
This ratio examines the relationship between sales and management-controllable costs before interest, taxes, and non-operating expenses. The operating margin is the ratio of operating income (sales less operating expenses) to sales for the same period. As with gross profit margin, you ideally would like to see a high operating margin that is steady over time.
This is probably the most oft-quoted ratio for any company. This “bottom line” margin indicates how well management has been able to turn sales or revenues into earnings available for shareholders.
While the first three profitability ratios examined profitability of sales, the next two measure the return on the assets and equity of the company. The first, return on assets, or ROA, examines the return generated by the assets of the firm. A high return implies the assets are productive and well managed.
Return on equity (ROE) extends the examination performed with the return on assets one step further and takes into account the financial structure of the company and its impact on earnings. ROE indicates how much the shareholders earned for their investment in the company. The level of debt or financial leverage on the company’s balance sheet has a large impact on this ratio. Debt magnifies the impact of earnings on ROE during both good years and bad. When you run across large differences between ROA and ROE, you should closely examine the liquidity and financial risk ratios, which are introduced later.
Knowing the liquidity of a company is important because it allows us to see how easily it could meet its short-term obligations. In Stock Investor, the liquidity ratios are the current ratio, quick ratio, payout ratio, and times interest earned ratio.
The current ratio compares the level of the firm’s most liquid assets—current assets—against that of its shortest maturity obligations—current liabilities. A high current ratio indicates a high level of liquidity and, consequently, less risk of immediate financial trouble. However, too high a current ratio may point to unnecessary investment in current assets, or an inability on the company’s part to collect accounts receivable, or an inflated inventory. Circumstances such as these ultimately have a negative impact on earnings. On the other hand, too low a current ratio implies illiquidity and the potential for the company to be unable to meet current liabilities in the event of random shocks (for example, strikes) that temporarily reduce the inflow of cash.
Similar to the current ratio, the quick ratio, sometimes called the acid test, is a more conservative measure. The quick ratio subtracts inventory from the current assets side of the comparisons, since inventory may not always be quickly converted into cash or may have to be marked down significantly to do so.
The payout ratio is the percentage of earnings a company pays out as dividends. Generally, “growth” firms have lower dividend payout ratios because they retain most of their earnings in order to fund future expansion. In contrast, “mature” or more established firms tend to have higher payout ratios as their investment possibilities diminish. The lower the payout ratio, the more secure the dividend moving forward. As payout ratios rise, the company runs the risk of having to cut their dividend if they have a cash shortfall.
Times interest earned, or the interest coverage ratio, is the traditional measure of a company’s ability to meet its interest payments. It indicates how well a company is able to generate earnings to pay interest on its debt. The larger and more stable the ratio, the lower the risk of the company defaulting. In addition, the higher this ratio, the more flexibility a company has in being able to meet its financial obligations and have money left over for dividends, expansion, etc. Interest on debt obligations must be paid, regardless of a company’s future potential. Failure to do so will result in default if the lender is not willing to restructure debt obligations. As this ratio falls, the risk of a company defaulting on its debt obligations increases. A ratio of less than one indicates that the company’s current earnings are not high enough to meet their current debt obligations, meaning that they will need to liquidate assets to make up for the shortfall or find additional funding.
The debt management ratios in Stock Investor—total liabilities to total assets, long-term debt to total capital, and long-term debt to equity—provide insight into the financial risk of the company.
The total liabilities to total assets ratio, also referred to as the debt to total assets ratio, measures the percentage of assets financed by all forms of debt—both current and long-term. The higher the percentage and the greater the potential variability of earnings translates into a greater potential for default.
The long-term debt to total capital ratio is a popular measure of financial leverage. It compares the level of long-term debt carried by a company to all sources of long-term financing—long-term debt and stockholder’s equity. This ratio is interpreted in the same way as the other debt management ratios—a high ratio indicates high risk. However, just because this ratio is low does not necessarily mean risk is low. You need to examine the level of current liabilities; if current liabilities are such that the company cannot meet these obligations, it runs the risk of defaulting.
The long-term debt to equity ratio also indicates what proportion of the firm’s capital is derived from debt as compared to common equity. A higher percentage of debt compared to equity increases the volatility of earnings as well as the probability that the firm will not be able to make its interest payments and default on its debt.
Asset management ratios examine the relationship between various elements of the company balance sheet—total assets, inventory, accounts receivable—and income statement items such as sales and cost of goods sold. In Stock Investor, there are three asset management ratios—total asset turnover, inventory turnover and receivables turnover.
Asset turnover, or total asset turnover, measures how well the company’s assets have generated sales. Industries differ dramatically in asset turnover, so comparisons to firms in similar industries are critical. Too high a ratio relative to other firms may be a sign that there are insufficient assets for future growth and sales generation. In contrast, too low an asset turnover ratio points to redundant assets or low productivity of existing assets.
The inventory turnover ratio is similar in concept and interpretation to (total) asset turnover, but looks at inventory instead of assets. Inventory turnover approximates the number of times inventory is used and replenished during the period under review. A higher ratio indicates that inventory does not languish in warehouses or on store shelves. Similar to total asset turnover, inventory turnover is very industry specific. For example, grocery stores must sell and replenish their inventories more quickly than jewelers.
Lastly, the receivables turnover measures the effectiveness of the firm’s credit policies and helps to determine the level of investment in receivables that is required to maintain the firm’s current level of sales. This ratio tells us how many times each period the company collects (turns into cash) its accounts receivable. The higher the turnover, the shorter the time between the credit sale and cash collection. A decreasing figure is a red flag that the company is not doing as good a job of collecting its receivables or that possibly the company is improperly booking credit sales in order to boost its revenues.
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