Chapter 10
On Your Ratio Dial: Using Ratios to
Ratio-nal Analysis
Before going too far with this discussion, it’s important to understand the benefits and limitations of ratios. Ratios are great tools and bring understand- ing to key parts of the financial statements. But realize that they are just tools, not a substitute for practical judgment. Ratios won’t automate your stock-picking decisions — they are a step along the way, not an “end-all”
analysis tool.
With that caution in mind, let’s examine the types of ratios, and, in a big-picture sense, how they’re used in practice.
Types of ratios
Ratios can be classified into one of four categories largely defined by what you’re testing for. These categories are covered in the following sections.
Asset productivity ratios
In Chapter 7, assets are defined as resources used in a business to produce a profit, or return. This group of ratios describes how effectively those assets are deployed or utilized. Some analysts call these efficiency or asset manage- ment ratios. How much inventory, accounts receivable, or fixed asset invest- ment does it take to support a given volume of business? Are these assets being managed effectively with proper controls?
Financial strength ratios
Company resources are provided either by company owners (shareholders) or by creditors (debt holders or holders of other obligations). These ratios measure to what extent company resources are provided by sources other than the owners. Sometimes called liquidity or debt management ratios, these ratios are also used to assess the company’s ability to pay its creditors and how vulnerable it may be to debt problems and high interest costs. They also describe financial or capital structure — that is, how financially leveraged a company may be.
Profitability ratios
How profitable is the company? Sure, there may be a lot of business activity.
But how much profit is produced? Per dollar sold? Per dollar invested? Some analysts refer to these ratios as management effectiveness ratios, as they indicate management’s overall success in generating returns for the enterprise.
Valuation ratios
The first three ratio families examine internal business fundamentals. With valuation the stock price enters the picture. Valuation ratios, as the name implies, relate a company’s stock price to its performance. The ubiquitous price to earnings (P/E) ratio shows up here, as do its siblings price to sales (P/S), price to book (P/B), and a few others.
Ratio information sources
Anybody with an annual report and a calculator can calculate and analyze ratios. Almost all ratios take a pair of numbers from a company’s balance sheet, earnings statement, or both.
Ratio analysis can be cumbersome and time-consuming, particularly when you’re looking at a group of companies or an industry. Services that “do” the numbers, and particularly the comparisons, for you are hard to find, espe- cially for free. Comparative industry ratio data is routinely available to pro- fessional financial and credit analysts, but they pay hefty subscription fees to get it.
Here are some ratio data and comparison sources:
Free:Yahoo! Finance and similar investing portals provide some ratios and limited comparison tools. The Yahoo! Finance “Key Statistics” page shows several ratios, mainly valuation ratios.
For a modest fee:At the time of this writing, there is still little available for the ratio-hungry investor to buy. One source is VentureLine (www.
ventureline.com), where, for $9.95, you can purchase a fairly com- plete rundown for a particular industry, such as “electronic computers.”
This product provides five years of data, making trend analysis practi- cal. While $9.95 per industry can add up if you invest in a lot of indus- tries, this tool is worth considering for investors doing a lot of ratio analysis.
More expensive:Value Line Investment Survey (www.valueline.com) offers a window to many key ratios. Value Line doesn’t present a lot or ratios, but does give a lot of history, which can be better. The basic Value Line subscription costs $598.00 per year but offers a lot beyond ratio analysis. (See Chapter 5.)
If you have access to Dun & Bradstreet or Standard & Poor’s industry finan- cial comparisons, don’t hesitate to use these rich, complete, and up-to-date resources as well. They may be out of reach of the average investor due to cost. If you work with a broker or financial advisor, you may get access to some of these services for free.
Using ratios in practice
What does a value investor look for when analyzing ratios?
Intrinsic meaning:What does the ratio tell you? If the debt-to-equity ratio is 3 to 1, the company has a lot of debt. If the inventory-to-sales ratio is greater than 1, the company turns its inventory less than once per year. A P/E ratio of 50 implies a 2 percent return on invested capital ($1 returned per $50 invested). These numbers tell you something without looking at any comparisons or trends.
Want an early test for determining whether a ratio is good, bad, or ugly?
Just think of the company’s ratio as it would apply to your personal finances. A household with 3 times as much debt as equity is in dire straits, as is a household that turns over inventory (say, groceries) only once a year, as is a household that achieves only a 2 percent return on its investments, or a household that’s owed a third of its annual income.
You can’t apply this test to all ratios, but where common sense tells you something, use it!
Comparisons:For many analysts, and especially credit analysts, who are trying to get a picture of a company’s health, comparative analysis is the most important use of ratios. A ratio acquires more meaning when it’s compared to direct competitors, the company’s industry, or much broader standards, like the S&P 500. A profitability measure, such as gross profit margin, reported at 25 percent tells more when direct com- petitors are at 35 percent plus. Analysts make similar comparisons with asset utilization, financial strength, and valuation ratios.
When doing comparisons, be in tune with what you’re comparing.
Companies can be in many different businesses at once. It’s tough to find pure plays in any industry. Realize that Dell Computer is almost 100 per- cent in the PC business, while Hewlett-Packard derives only 25 percent of revenues from PCs. A company mostly in the health insurance business may be difficult to compare to a company that sells mostly life insurance.
Borders Group and Amazon, while classified in the same industry, have very different business structures. While the resulting ratio differences may in part be valid, they also may lead you to believe that an apple is bad when it really isn’t. It’s important to compare apples to apples when comparing different companies.
Consistency:The hallmark of good management, as well as of an attrac- tive long-term investment, is the consistency of results delivered. If profit margins are consistent and changing at a consistent rate, the company is predictable — and most likely in control of its markets. Inconsistent ratios reflect on inconsistent management, competitive struggles, and cyclical industries, all of which diminish a company’s intrinsic value.
Trends:Better than consistency alone is consistency with a favorable trend. Growing profit margins, return on equity, asset utilization, and financial strength are all very desirable, particularly if valuation ratios (P/E and so on) haven’t kept pace. Value investors who study trends carefully have information that most investors don’t have.
What’s on the Ratio Dial
This section details the important ratios in each category, or “type” identified earlier. We offer examples from the Simpson Manufacturing 2006 financial statements appearing in Chapters 6 through 8, so you’ll want to refer to these exhibits as you read what follows.
Note: When using items from the earnings statement in the numerator or denominator of a ratio, the figure used typically represents either the previ- ous fiscal yearor the trailing 12 months(TTM) of business activity. Balance sheet items come from the most recently reported period. The terms sales and revenueare used interchangeably.
Asset productivity ratios
Asset productivity ratios describe how effectively business assets are deployed. These ratios typically look at sales dollars generated per unit of resource. Resources can include accounts receivable, inventory, fixed assets, and occasionally other tangible assets. Similar analyses may also be done not just for financial assets but also for operational assets like square footage, number of employees, number of facilities, and airplane seat miles.
Receivable turnover
Receivable turnover measures the size of unpaid customer commitments to a company. Specifically, it measures how many times a year this asset turns over; that is, is cleared out and replaced by similar obligations from other customers. Rapid turnover, not lingering old debts, is what you want to see.
Here’s the formula:
Receivables turnover = sales $ ÷ accounts receivable $
For Simpson $863.2 million ÷ $107.2 million = 8.1 (from Figure 7-1), a relatively weak turnover for most businesses. Another way to look at it: For every dollar invested in receivables, about $8 comes back to the company in sales.
Accounts receivable is a resource at a company’s disposal like anything else and must be paid for, essentially, by sacrificing cash that otherwise would be available to fund some other part of the business. A company selling direct to consumers with cash sales or bank credit card sales will have lower receiv- ables turnover than an industrial supplier. Watch for consistency and compli- ance with normal billing policy for the industry.
Average collection period (or days’ sales in receivables)
A slightly different way of looking at receivables is to show the average number of days that a given receivable dollar lives on the books. To calculate, divide the receivable turnover ratio (from the preceding section) into 360 to put it on a daily scale:
Average collection period = 360 ÷ receivables turnover
So for Simpson, 360 ÷ 8.1 gives 44.4 days of life for the average receivable dollar on the books. For an industrial supplier with a standard 30-day billing cycle, a model that Simpson would normally fit, you’d expect 30 days or less worth of sales in receivables, as most customer accounts would be billed in
“net 30” due date terms. These figures suggest something may be amiss with Simpson — or that the company may have different collection policies than industry norms. Investors would want to put a “watch” on this figure to see if it gets better or worse.
If, based on industry comparisons or stated billing cycles, the collection period is higher than it should be (or growing), watch out. The company may be losing control of its collections or selling to customers with questionable credit. This ratio is also sometimes called days’ sales in receivables.
Inventory turnover
Inventory turnover works like receivables turnover, only you plug in balance sheet inventory in place of receivables. Here’s the formula:
Inventory turnover = sales ÷ inventory $
As with receivable turnover, the higher the number the better. High numbers indicate that raw materials, works in progress, and finished goods are flying onto and off of shelves rapidly. Less dust collects on less stuff in fewer ware- houses, and less cash is tied up in inventory. Also, there’s less risk of obsoles- cence and write-offs, and in many businesses, less risk of markdowns to clear inventory.
Simpson Manufacturing had $863.2 million in sales on $217.6 million in inven- tory for an inventory turnover ratio of about 4. Again, a yellow flag may go up, because as we discuss next, it implies that inventory stays on the shelves for an average of three months — not too good for a company that sells most of its product into a sales channel rather than directly.
Deciphering asset productivity ratios means knowing something about the business a company operates in. If bookseller Borders Group has a large inventory for its sales, it’s helpful to know that in the bookselling business, shelf inventory is fully returnable to publishers, mitigating inventory risk and providing reader selection — all justifying higher levels of inventory. Know thy industry!
We saw that the average Simpson product sits on the shelf for three months, (360 ÷ 4 gives 90 days, or three months). “Days sales in inventory” or “aver- age inventory shelf life” or “months of supply” measures are used extensively as internal business measures, especially in manufacturing and distributions businesses, to help put inventory levels in perspective.
Fixed asset turnover
This ratio is straightforward:
Fixed asset turnover = sales $ ÷ fixed asset $
Obviously, all else being equal, the company that produces the most sales or revenue per dollar of fixed assets wins.
Total asset turnover
Again, straightforward:
Total asset turnover = – sales $ ÷ total asset $
Here we get a bigger picture of asset productivity as measured by the genera- tion of sales. For the first time, intangible assets are included. Again, industry norms form the benchmark. Comparing a railroad to a software company probably doesn’t make sense.
Nonfinancial productivity ratios
Operational, or capacity utilization ratios, can be quite interesting, yet some- times hard to find or apply. The raw data is often not available in company statements or published reports. Calculated ratios are even harder to find, although Value Line and other analysis services make it a point to present certain nonfinancial operating data. These measures vary by industry, but here are some examples:
Sales per employee: This ratio tells you how productive a company is in regard to investments in human resources. We think it’s worth a look in almost all industries, particularly those that are labor intensive, such as retail, transportation, and other service industries.
Sales per square foot:This ratio is especially important for retail and similar businesses where occupancy investments are large and sales can be tied directly to them.
Average selling price (ASP): Many financial reports don’t present the number of units sold because they don’t have to — and they want to keep selling prices secret. But sometimes this data is available (for example, from Boeing and other very-large-ticket manufacturers), and it can be quite revealing as to the direction of a business.
Industry specials:Airlines and airline investors pay close attention to seat miles and revenues per seat mile flown. Railroads may look at rev- enue per track mile or car mile. Other service businesses such as banks, mail order retail, and such may look at sales or revenue per customer.
Sometimes important information can surface in relatively easy-to-find places. Employee count figures appear on the Yahoo! Finance “Competitor Comparison” page, and industry-specific figures such as airline seat-miles flown can appear in trade-specific publications or Web sites. Seat-miles flown, in fact, can be found on the U.S. Department of Transportation Bureau of Transportation Statistics Web sites (www.bts.gov), along with lots of com- parable information for airlines and other transport businesses.
Financial strength ratios
This set of ratios goes by many names (liquidity, solvency, financial leverage), but they all point to the same thing: What is a business’s financial strength and position? What is its capital structure? A balance sheet oriented value investor looks closely to make sure that the company will be around tomor- row (as many investors did in the 1930s). A value investor first looks at financial strength ratios for obvious danger, then bases the bulk of his intrin- sic value analysis on business-strength and market-strength measures like productivity and profitability.
Current and “quick” ratios
These commonly used liquidity ratios help evaluate a company’s ability to pay its short-term obligations. Here’s the formula:
Current ratio = current assets ÷ current liabilities
The current ratio includes all current assets, but since inventory is often diffi- cult to turn into cash, at least for a reasonable price, many analysts remove it from the equation to arrive at a quick ratio. The quick ratio emphasizes cov- erage assets quickly convertible into cash:
Quick ratio = (current assets – inventory) ÷ current liabilities
Another ratio, cash to debt, is often used. The calculation is self-explanatory.
It takes a still more conservative view of coverage assets (cash only) and a clearer view of what needs to be covered (total debt, current and long-term portions).
The traditional thinking is that the higher the ratio, the better off the com- pany. Greater than 2:1 for the current ratio or 1:1 for the quick ratio is good and safe; less than 2:1 or 1:1 is a sign of impending problems meeting obliga- tions. Simpson, for example, has a healthy current ratio of almost 6 ($479.3 million ÷ $80.3 million). The “quick” ratio of 3.25 [($479.3million – $217.6 mil- lion) ÷ $80.3 million] is also not bad. If some unknown force caused Simpson’s current liabilities to be due and payable immediately, they’d have plenty of coverage. Again, it’s helpful to think of your own personal financial situation as a comparison.
More recent thinking, exemplified by the strong historical performance of Dell Computer, doesn’t always hold liquidity in the highest esteem. Dell became famous for tying up as little cash as possible in current assets and instead relying on its suppliers to deliver “just in time.” So current asset totals were small, while current liabilities were moderately higher, and some ratios came in under 1. But really, Dell was just living off of cash invested by suppliers in their receivables (Dell’s payables). Living off the assets of others is a good technique — if you can get away with it.
The value investor’s general rules for liquidity ratios: First, compare liquidity to industry norms and watch for unhealthy trends (as with other ratios).
Second, and important, liquidity ratios don’t tell you so much what to buy as what not to buy.
Debt to equity and debt to assets
Sometimes also called solvency, or leverage, ratios, this set measures what portion of a firm’s resources, or assets, are provided by the owners versus provided by others.
Financial leverage can be a good thing — to a point, and as long as things are going well. If you put up $1, borrow $9, and invest the $10 total to achieve a 10 percent return, your profit is $1. Your return on equity is 100 percent (your
$1 profit divided by the $1 invested). But what if you lose $2? Your creditor still wants his or her $9 back and is entitled to it. You lose your entire invest- ment and then some. On top of that, your creditor demands (and is entitled to) a fixed level of interest payments, which is a constant expense to your enterprise regardless of results. Leverage is thus a double-edged sword.
Too much long-term debt costs money, increases risk, and can place restric- tions on management in the form of restrictive lender covenants governing what a company can and can’t do, minimum performance levels, and so on.
The two most common ratios used to assess solvency and leverage are debt to equityand debt to total assets. Here’s the formula for debt to equity:
Debt to equity = total debt ÷ owner’s equity