Fundamental Analysis: Financial Ratios

primary source: Understanding Financial Statements by James O. Gill and Moira Chatton.

What are ratios?

Ratios are tools to help you analyze a business. Ratios measure proportions. Ratios also measure relationships. They do this because they can translate assets, such as tools and inventory, and liabilities, such as payable and loans, into common dollar figures. By doing this it is easy to see valuable relationships between two seemingly unrelated items. Ratios also allow you to make comparisons between time periods and between different businesses.

It is important to remember that all tools will never be used all the time.

If ratios are used improperly, it could mislead you. The proper use of ratios takes into consideration the economy, the business cycle, whether a business is growing or has reached maturity and the type of business.

What is significant?

To determine which ratio to use, consider the type of business, the point in business cycle and what you are looking for. For instance, one type of business might require a large number of fixed assets, buildings, land, equipment, tools, etc. while another requires very few. The significant ratios in the first case would be those that help you measure how well the business is using its fixed assets.

Another type of business may need to carry a well-stocked inventory or perhaps just enough to satisfy emergency needs. In either case, inventory turnover is critical, and if it gets out of hand, the business may not be able to pay current expenses on the one hand, or have the stock to satisfy its customers on the other.

Some businesses are dependent upon seasonality for their income. That is, more sales occur during certain period of the year than any other. During each rise and fall of this cycle, ratios can be quite different. It becomes necessary to watch these periods so the ratios reflect what is needed. For example, if a business is expecting a big sale (Christmas time for retail businesses), but is has not come through, the business needs liquidity to carry through. If it sells on credit, it has to watch its collection time between the sale and the payment or it will face a lack of working capital.

If one ratio goes up will another go down?

Sometimes they do. But ratios generally don't work out so nicely.

Sometimes two or more ratios indicate good work and both will be high. Sometimes, depending on the type of business or the time in the business cycle, one will be low, or it won't make any difference what a ratio does.

Four Types of Ratios

Liquidity Ratios

Liquidity Ratios measure the amount of cash available to cover expenses both current and long term. These ratios are especially important in keeping a business alive.

Current Ratio

Current Ratio measures the ability to meet short term obligations.

Generally accepted standard is 2 (current assets should be 2 times or 200% of current liabilities).

Low Ratio means a company may not be able to pay off bills as rapidly as it should.

High Ratio means that money that could be working for the business is tied up in government securities, cash savings or other safe funds.

Quick Ratio

The same as Current Ratio, except that it eliminates inventory so that only cash and accounts receivable assets are counted.

Measures immediate liquidity or the cash available to cover immediate liabilities. A safe margin would be at least 100%.

Leverage Ratio

A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt (loans), or assesses the ability of a company to meet financial obligations.

Financial leverage is defined as total assets divided by total shareholders' equity. The higher the ratio, the more debt a company uses in its capital structure.

The financial leverage ratio is sometimes referred to as the equity multiplier. For example, a company has assets valued at $2 billion and stockholder equity of $1 billion. The equity multiplier value would be 2.0 ($2 billion / $1 billion), meaning that one half of a company’s assets are financed by equity. The balance must be financed by debt.

Turnover of Cash Ratio

Measures the turnover of cash or working capital. Maintaining a positive cash flow or working capital balance is essential to finance sales without struggling to pay for the material and/or goods a company is buying.

Generally accepted standard: sales should be 5-6 times working capital.

Low Ratio means a company may have funds tied up in short-term low-yielding assets, which means that company may get by on less cash. It also means that a company may have a cash surplus, which is not invested in the business.

High Ratio means that company is vulnerable to creditors. As a result it may be unable to pay wages or utility bills.

Usually, if the current ratio is low, the turnover of cash ratio will be high. This is due to the small amount of working capital that is available.

Debt to Equity Ratio

Debt Ratio expresses the relationship between capital contributed by the creditors that loan a business cash and owner's equity remaining in the business.

Some analysts feel that current liabilities to net worth should not exceed 80% and long term debt should not exceed net worth by 50%.

Low ratio means greater long term financial safety. An extremely low ratio may mean that the firm's management is too fiscally conservative, which may indicate that a business is not reaching its full profit potential, that is, the profit potential from leverage.

High Ratio indicates that greater risk assumed by creditors, hence greater interest by them in the way the company is being managed. It also indicates a limited ability to obtain money from outside sources.

Remark: A lot depends on where business is in its life cycle. Long term debt is leverage and leverage can work for a business during the good time and work against it during a sales slump.

Profitability Ratios

Profitability Ratios measure and help control income. This is done through higher sales, larger margins, getting more from expenses and/or combination of these methods.

Rate of Return on Sales

Measures how much operating income (net profit) was derived from every dollar of sales. It indicates how well a company have managed its operating expenses. It may also indicates whether the business is generating enough sales to cover the fixed costs and still leave an acceptable profit.

The value of this ratio depends on the business and/or industry. Price and volume are important and play a large role in determining the ratio. Usually the higher ratio the better. However, if the company is beating last year's figures and show steady increase, it is on a right track.

Return on Assets (ROA)

Return on Assets measures the income (profit) that is generated by the use of the assets of the business.

ROA varies a great deal depending on the industry and the amount of fixed assets required by the business.

Low ratio usually means poor performance, or ineffective use of assets by management.

High ratio usually means good performance, or effective use of assets by management.

Remarks: This ratio should be used with other ratios to compare firms in the same industry and approximately the same size. It is a valid tool if you know the real value of the competitor's assets and whether they are including outside earnings as a large part of their current assets.

Return on Investment (ROI)

Return on Investment measures return on owner's investment. Some investors use this figure as a final evaluation to determine whether or not to invest in a company. This ratio is often called return on equity (ROE).

A return on investment of 15% is generally considered necessary to fund future growth from within a business. This means that a business will not be dependent on financing its growth with long term debt, but will be able to generate the income from its own operations.

Low ratio indicates inefficient management performance or it could reflect a highly capitalized, conservatively operated business with little long term debt.

High Ratio could mean that creditors were a source of much of the funds used in the business, management is efficient or the firm is undercapitalized (has minimal long term debt).

Remarks: This measure is considered one of the best criteria of profitability; it can be a key ratio to compare against other firms or the industry average.

Return on Invested Capital (ROIC)

Return on Invested Capital used to assess a company's efficiency at allocating the capital under its control to profitable investments. The return on invested capital measure gives a sense of how well a company is using its money to generate returns. Comparing a company's return on capital (ROIC) with its cost of capital (WACC) reveals whether invested capital was used effectively.

A return on Invested Capital of 15% is generally considered necessary to fund future growth from within a business. This means that a business will not be dependent on financing its growth with long term debt, but will be able to generate the income from its own operations.

Efficiency Ratios

Efficiency Ratios measure and help control the operation of the business. These ratios provide an indication of how fast a business is collecting its money for credit sales and how many times it is turning over inventory in a given period of time.

Efficiency Ratios are an important benchmark to keeping a business in balance. For instance, if a business become too loose in offering credit to generate sales, this will show up as an increase in the average number of days it takes to collect accounts receivable.

Average Collection Period Ratio

The turnover of receivables is the average number of days it takes to collect cash from the credit sales. Generally everything within 10 to 15 days is deemed acceptable and considered within the collection period.

Low ratio means a fast turnover, which could be the result of a stringent collection policy or fast-paying customers.

High Ratio means a slow turnover, which may be the result of a number of bad accounts, or a tax collection policy or perhaps credit is being used to generate sales.

Inventory Turnover Ratio

Measures how fast the company's merchandise is moving. In other words, how many times the initial inventory is replaced in a year. The rule of thumb is 6-7 times per year is a healthy inventory turnover ratio. Faster turnovers are generally viewed as a positive trend; they increase cash flow and reduce warehousing costs.

Low Ratio is an indication of a large inventory, a never-out-of-stock situation, perhaps some obsolete items, or it could indicate poor liquidity, some possible overstocking of items or a planned build-up in anticipation of a coming high-selling period.

High Ratio is an indication of a narrow selection, may be fast moving merchandise, or perhaps some lost sales due to lack of stock. It may also indicate better liquidity or even superior merchandising.

Fixed Asset Turnover Ratio (Net Sales to Fixed Income)

Fixed Asset Turnover Ratio measures management's effectiveness in generating sales from investments in fixed assets. It is very important for a capital intensive business. In general, the value between 3 and 5 is considered healthy, but must be viewed on a business's expectations. This ratio should only be used to compare firms within the same industry group.

Low Ratio means that the assets may not be fully employed or too many assets may be chasing too few sales.

In general, the higher the ratio, the smaller the investments needed to generate sales which means greater profitability.

Profit Margin Ratio (Net Profit Margin)

Profit Margin Ratio measures how much out of every dollar of sales a company actually keeps in earnings.

Profit margin is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors.

Market Ratios

Market Ratios are primarily used by investors to determine whether or not to purchase stock in a company and includes commonly used Earning Per Share (EPS), Price Per Earnings (PE), etc.

Beta

The beta is a measure of a stock's price volatility in relation to the rest of the market. In other words, how does the stock's price move relative to the overall market.

The whole market, which for this purpose is considered the S&P 500, is assigned a beta of 1. There is no single index used to calculate beta, although the S&P 500 is probably the most common proxy for the market as a whole.

Stocks that have a beta greater than 1 have greater price volatility than the overall market and are more risky. Stocks with a beta of 1 fluctuate in price at the same rate as the market. Stocks with a beta of less than 1 have less price volatility than the market and are less risky.

Beta seems to be a great way to measure the risk of any stock. If you look a young, technology stocks, they will always carry high betas. Many utilities on the other hand, carry betas below 1.

Alpha

Alpha is a measure of the active return on an investment, the performance of that investment compared with a suitable market index.

An alpha of 1% means the investment's return on investment over a selected period of time was 1% better than the market during that same period; an alpha of -1 means the investment underperformed the market. Alpha, along with beta, is one of two key coefficients in the capital asset pricing model used in modern portfolio theory.

Sharpe Ratio

Sharpe Ratio (also known as the reward-to-variability ratio) is a way to examine the performance of an investment by adjusting for its risk. The ratio measures the excess return (or risk premium) per unit of deviation in an investment asset or a trading strategy, typically referred to as risk, named after William F. Sharpe.

The Sharpe Ratio characterizes how well the return of an asset compensates the investor for the risk taken. When comparing two assets versus a common benchmark, the one with a higher Sharpe ratio provides better return for the same risk (or, equivalently, the same return for lower risk).

The Sharpe Ratio compares stock performance with a "risk-free interest rate". It means that Sharpe Ratio will be negative when stock performance is lower than defined risk-free rate.

In practice, a risk-free bond is usually chosen—that is, one issued by a government or agency whose risks of default are so low as to be negligible. Stock2own uses a constant 5% as a risk-free rate of interest.

The Sharpe Ratio is a risk-adjusted measure of return which can be used to compare different investment instruments. In general, a ratio of 1 or greater is considered good; 2 or better is very good; and 3 or better is considered excellent.

Debt to Free Cash Flow

As Phil Town stated in his book "Rule #1": To determine whether a business's debt is reasonable, find out if it can pay off its debt within three years by dividing total long-term debt by current free cash flow.

PE Ratio (PE)

The PE ratio (price-to-earnings ratio) of a stock (also called its "P/E", "PER", "earnings multiple", or simply "multiple") is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher PE ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower PE ratio. The PE ratio has units of years, which can be interpreted as "number of years of earnings to pay back purchase price", ignoring the time value of money. In other words, PE ratio shows current investor demand for a company share.

The average U.S. equity PE ratio from 1900 to 2005 is 14 (or 16, depending on whether the geometric mean or the arithmetic mean, respectively, is used to average). An oversimplified interpretation would conclude that it takes about 14 years of earnings to recoup the price paid for a stock (not including any additional income from the reinvestment of those earnings).

Normally, stocks with high earning growth are traded at higher PE values.

Earnings per Price (EP) Ratio

EP is Earnings per Price ratio or Earnings Yield. It is a reverse ratio of PE:

EP = 1 / PE

EP measures an after-tax cost of raising expansion capital compares to borrowing long-term debt through bonds, for example.

A PE of 20 is really a price of $20 divided by $1 of earnings. So the EP for this is 1 divided by 20, or 5%. When you think of the relationship as an earnings yield, it compares better to interest rates, and the heights framework scaring us about PE disappears instantly. The PE of 20 scares you, but the earnings yield of 5% does not. … Since stocks and bonds compete for investor dollars, the comparison of bond yield and stock earnings yields gives you something concrete for comparison.

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Price/Earnings To Growth (PEG) Ratio

PEG Ratio is a stock's price-to-earnings ratio divided by the growth rate of its earnings for a specified time period. The price/earnings to growth (PEG) ratio is used to determine a stock's value while taking the company's earnings growth into account, and is considered to provide a more complete picture than the PE ratio.

While a high PE ratio may make a stock look like a good buy, factoring in the company's growth rate to get the stock's PEG ratio can tell a different story. The lower the PEG ratio, the more the stock may be undervalued given its earnings performance.

The PEG ratio that indicates an over or underpriced stock varies by industry and by company type, though a broad rule of thumb is that a PEG ratio below one is desirable. Also, the accuracy of the PEG ratio depends on the inputs used. Using historical growth rates, for example, may provide an inaccurate PEG ratio if future growth rates are expected to deviate from historical growth rates.

Price/Earnings To Growth and Dividend Yield (PEGY) Ratio

For stocks that pay a substantial dividend, the PEGY may be an even better measure than PEG. As with the PEG.