If you have read the financial statements for a company, you know you have lots of data and even too much data. You can meet that challenge, however, by digesting that data into key ratios.
Ratios allow us to compare a company’s performance over time, even many years, in what is called a “time-series analysis.” When used this way, ratios also help us identify trends over specific time periods. Ratios also allow us to compare one company with other companies; this is called “cross-sectional analysis.”
Our guide to analysis through ratios is chapter five of the 2014 book, “Strategic Value Investing: Practical Techniques of Leading Value Investors,” written by Stephen Horan, Robert R. Johnson and Thomas Robinson.
As they noted, “A virtually unlimited number of ratios can be computed from the various available financial statements and other metrics.” To organize them, they created the following table, which categorizes the ratios:
They pointed out that, regardless of category, the ratios are all related; for example, a company that operates with poor profitability and low efficiency will normally trade at a lower price multiple than its peers.
Here are some common ratios, but consider these just a sampling of the many available.
Activity ratios
- Inventory management: Essential numbers for analyzing many sectors, especially manufacturing and retail. Common ratios include inventory turnover and days inventory.
- Receivables management: After inventory is sold, how long does it take to collect from customers? Two common metrics are accounts receivable turnover and days sales outstanding.
- Asset turnover: How efficiently is the company employing its assets? A prominent metric is the total asset turnover ratio.
Liquidity ratios
- Current and quick ratios: The current ratio simply divides current assets by current liabilities, and a ratio of more than one suggests positive working capital (enough to cover liabilities for the coming year). The quick ratio does not include all current assets, just cash, short-term investments and accounts receivable. They are summed and divided by current liabilities; again, a number higher than one indicates the company should have enough “quick” assets to cover the coming year’s liabilities.
Solvency ratios
Unlike the liquidity ratios, the solvency ratios help us understand how well a company is placed to handle its long-term obligations. Metrics include:
- Debt ratio: This is simply total liabilities divided by total assets and measures what proportion of the assets were financed with liabilities (from external claimholders).
- Debt-to-total capital: Similar to the debt ratio, but represents the relative proportions of debt and equity financing.
- Coverage ratios: Working with data from the income statement, these ratios allow analysts to know how much leeway a company has in meeting its debt obligations. An example of such a metric is the interest coverage ratio, which is also called the times interest earned ratio.
Profitability ratios
Also called return ratios, these are important to value investors because they show how profitable the company has been in terms of its revenue or on how much capital has been invested in it.
- Common size ratios, or return on sales: Each line item on a financial statement can be measured as a percentage of sales. This makes it easier to compare profitability across companies of various sizes. These are some of the items that are analyzed: gross profit margin, operating margin, pretax margin and net profit margin.
- Return ratios: These measure profitability against investments in the company. Such metrics include return on assets, return on owners’ equity and return on assets.
Cash flow ratios
As the authors pointed out, “While accounting profits are nice, employees, creditors, and investors prefer to get paid in cash. Additionally, some firms have been aggressive (in an accounting sense) in reporting earnings. An examination of cash flow ratios can provide insight into the quality of a firm’s earnings.”
- Operating cash flow to liabilities: Provides a picture on a company’s ability to meet its obligations.
- Operating cash margin: Shows profitability on a cash flow basis.
- Cash return on assets: This shows how much was cash was generated on the company’s assets; for example, a 10% cash return on assets signals that the company has earned $10 in operating cash flow for each $100 of total assets.
- Cash flow earnings index: Compares cash flow from operating activities to net income.
- Free cash flow ratio: Shows what proportion of cash flow is available for other initiatives, once capital expenditures are funded.
Price multiple ratios
Such ratios are also called price multiples or market multiples and they can be helpful in comparing a company’s relative valuation with its peers or the market as a whole.
- Price-earnings ratio: Shows how the market values a company’s common stock; a higher price-earnings ratio indicates the company is highly valued (and perhaps overvalued), while a low ratio suggests the market doesn’t like a company’s stock. A company with a low multiple and strong fundamentals (such as profitability) would be of strong interest to a value investor.
- Price-book ratio: This is the stock price divided by the book value per share. The authors wrote, “A high price-to-book ratio indicates that the market is valuing the firm richly compared to the accounting book value of the underlying net assets. Firms with strong profitability and growth prospects tend to have high P/B ratios.”
- Price-sales ratio: How the market values a company’s stock in relation to its sales or revenue.
- Price-cash flow ratio: Similar to the price-earnings ratio, it is used when an investor is analyzing companies on a cash flow, rather than earnings, basis.
Conclusion
In this overview of ratios and ratio categories, the authors of "Strategic Value Investing: Practical Techniques of Leading Value Investors" have introduced some of the best-known, and most helpful, metrics used by investors.
They are essential for value investors who seek to identify intrinsic values by analyzing important data points from a company’s financial statements. With ratios, individual numbers are given extra meaning by putting them in the context of other numbers from the financials.
Read more here:
- Strategic Value Investing: Company Analysis, Part 2
- Strategic Value Investing: Company Analysis, Part 1
- Strategic Value Investing: Industry Analysis
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