Financial Ratio Analysis For Dummies: Valuation, Debt And Liquidity Ratios

  • Importance of ratio analysis for the financial community.
  • Detailed understanding of valuation, debt, liquidity and other financial ratios.
  • How to compare firms with their peers using these financial ratios.
  • Caution to be exercised while doing financial ratio analysis.

Ratio analysis is an important part of any financial analysis. In today’s world we are inundated with information and numbers. It is difficult to sift through all the data and put a positive or negative value to them. Financial ratios help in making the task much simpler by providing easier comparison parameters. For example if a firm has a profit of $200 million it is supposed to be better than another firm earning $100 million. However ratio analysis can help us pinpoint on what equity and capital base these earnings are made showing the strengths or weakness within the numbers.

There are huge numbers of ratios however we can understand them easily by categorizing them. We will look at International Business Machines (NYSE:IBM) as an example to understand these financial ratios.

Valuation Ratios

A very important part of ratio analysis is that they help in the valuation of a firm. We look at some of the most important ratios for valuation.

  1. Price Earnings Ratio

Also known as the PE Ratio this is one of the most quoted ratios within the investing world. It does have its shortcomings however it is a good measure which helps in finding how the company is valued quickly.

P/E Ratio = Price of stock per share/ Earnings per share (EPS)

IBM stock was priced at $153.3 as on Jan 30, 2015 and its EPS (ttm) was $11.90. This gives us a P/E ratio of 153.3/11.90 = 12.88

During bull markets this PE ratio would increase due to inflated prices whereas during bearish periods the P/E falls. It has been seen that the average P/E across the market is 15. However higher growth companies especially internet stocks can command a much higher PE ratio. A very good example of a high PE stock is Amazon (NASDAQ:AMZN). Amazon's sky high PE ratio has always been justified saying the company is a growth stock but a deeper look at the fundamentals suggest otherwise. On the other hand, matured companies like IBM have reasonable PE ratio. Amazons P/E is in the negative whereas IBM has a PE of 13.75 (as of Feb 19, 2015). (For detailed analysis of AMZN stock, watch Amazon stock analysis.)

amzn pe ratio
Fig 1: Amazon PE ratio chart by Amigobulls

  1. Price to Sales Ratio (P/S Ratio)

Where earnings are concerned there is a good deal of possibility for manipulation by the management. However it is difficult to play with the final sales figure of a company. This is the reason why many investors believe that a P/S figure is much more important than a P/E ratio.

P/S Ratio = Price of stock per share/ Sales (Revenue) per share

For IBM: P/S = 153.3 / ($93.35 B/1.01 billion shares) = 1.65

This ratio will differ a lot between different industries. A retail giant like WalMart (NYSE:WMT) will have higher sales and a much lower PS ratio owing to higher denominator and lower profit margins. Whereas a higher growth company like Facebook (NASDAQ:FB) has much higher PS ratio due to greater growth potential and low revenue base. (Also watch Facebook stock analysis for a detailed fundamental analysis of this social media giant)

  1. Profit/ Earnings to Growth (PEG) ratio

The shortfalls within PE ratio are remedied to a great extent through this ratio. PE ratio can not actually state the reason why a stock is getting a higher PE ratio or lower other than a general bullish/bearish expectation within the market. However PEG ratio uses P/E ratio and the expected EPS growth to find if the stock is overvalued or undervalued. If a company has a PEG ratio of 1 it is said to be fairly valued, a higher than 1 figure shows overvalued stock, and lesser than 1 shows undervalued stock.

PEG Ratio = (P/E ratio) / Estimated EPS growth

Within this formula the final calculations differ based on the estimated growth figures. Ex: Yahoo (NASDAQ:YHOO) calculates PEG ratio by using estimated EPS growth for next five years and P/E ratio is calculated using EPS figures for the present fiscal year. However Nasdaq uses estimated EPS growth for the next year only using consensus of analyst estimate.

Using Yahoo’s method we get IBM’s PEG: 9.43/4.51 = 2.1

(Numerator is forward P/E ratio and denominator is estimated annual EPS growth rate for next five years). According to these estimates IBM is currently overvalued. Similarly Facebook on the other hand has a PEG ratio: 39.24/32.42% = 1.21. This is near the ideal ratio of 1 and shows that it is fairly valued. PEG ratio provides a good rational for higher P/E valuation. If a company is projected to have higher EPS growth in the future it can have higher P/E ratio and hence a higher price for every dollar earned.

As we can see, IBM which is a mature company in a low growth sector has a lower P/E forward ratio of 9.43 but still gives an overvalued ratio due to lower growth projections (4.51%) whereas Facebook which is in the higher growth sector has a much higher P/E forward ratio of 39.24 and still shows a fair valuation due to higher growth projections (32.42%)

Criticism: This ratio is criticized as it is based on the analyst estimates which have been wrong in the past. If the estimates for EPS growth are high for the future the PEG ratio will fall and show the firm as undervalued. However the actual EPS growth might be different. Hence proper analysis of EPS projections is required before calculating PEG ratio.

  1. Value Per Active User

With the growth new technology companies newer ratios have been created to help in finding an ideal valuation point. Many tech companies do not have any profits at the time of their IPO and sometimes even post that. Yet they have valuations in tens of billions of dollars. To value such internet stocks, we have a metric called the value per active user. This is based on the level of engagement an active user has and is highly relevant for social media stocks.

Fig 2: Comparison of various social media platforms by value for every active user in 2014

As seen from the chart it is evident that Facebook is the most valuable social media company with the value per active user at $141. This difference in the final values is based on the ability of the platform to monetize its operations. There are other ratios which are also used like Price/Book value ratio, Cash Flow coverage ratio and dividend yield for getting a correct valuation of a firm.

Debt Ratios

These financial ratios show the level of debt used by the company to manage its operations and whether it has the requisite amount to cover the interest payments.

  1. Debt-Equity Ratio

This ratio shows the liabilities of the company in comparison to the equity put by shareholders. A lower ratio shows that the company is using less leverage and has a good equity position. On the other hand a very high ratio would show that the creditors of the company are putting more money into the company than the shareholders themselves.

Debt-Equity ratio = Total Liabilities/ Shareholder's Equity

IBM’s Debt-Equity ratio: $40.80 billion/ $12.03 billion = 3.39. Compared with other technology companies this is quite high. For example, Apple (NASDAQ:AAPL) has a Debt/Equity ratio of 0.29.
ibm debt equity ratio
Fig 3: Debt to equity ratio for IBM in the past 10 years

Well established firms are able to take greater debt on the back of their strong and sustainable operations. Also a very low ratio is not considered good as it shows that the firm is not using debt to its full capacity to boost growth.

  1. Interest Coverage Ratio

This ratio shows how easily a firm is able to pay the interest expense on its debt. A very high ratio will show that the firm can comfortably meet its interest obligations whereas a very low ratio of 1.5-2 will show that the firm will find it difficult to meet its current interest expenses and will not be able to take any future debt.

Interest Coverage Ratio = Earnings before Interest and Taxes (EBIT) / Interest Expense

IBM’s interest coverage ratio: EBIT/Interest Expense= $23.54 billion/ $0.48 billion = 48.9. This shows that IBM is earning over 48 times the interest obligation which puts it in a comfortable position to meet any emergencies.

Generally utility and telecom firms have to monitor this ratio closely as they require heavy leverage within their operations.

  1. Cash Flow to Debt Ratio

This ratio shows what part of total debt a firm can cover through its annual cash flow earnings.

Cash Flow to Debt Ratio = Operating Cash Flow/ Total Debt

IBM's cash flow to debt ratio: $16.9 billion/ $40.8 billion =0.41. This means that IBM would need 2.5 years cash flow to fulfill its debt obligations. Cash rich Apple on the other maintains lower debt obligations hence its ratio is: $70.76 billion/ $36.4= 1.94. This shows that it can cover its debt obligations in less than a year's cash flow. (For more details on Apple valuation, watch our Apple stock analysis)

Other ratios like Debt ratio and Capitalization ratio are also looked at to find if the company is not overly leveraged and can meet its payment obligations.

Liquidity Ratios

Liquidity ratios look at the ability of a firm to meet its short term debt obligations. If a company has a low proportion of ready available cash or assets to meet its current obligations it will face short term operation problems.

  1. Current Ratio

The short term assets of a company should be able to pay off its short term obligations comfortably. Current assets include Cash, Marketable securities, inventory and receivables whereas current liabilities include payables, tax expenses, current portion of long term debt and accrued expenses.

Current Ratio = Current Assets/Current Liabilities

IBM’s Current ratio: $49.42 billion/$39.6 billion = 1.25

Fig 4: IBM has maintained a good level of current ratio however during the financial crisis there was a momentary dip in this ratio.

Most of the major tech firms keep a good buffer to manage their business operations.

  1. Quick Ratio

Although current ratio is a good reference point on how a firm manages its short term obligations and payments, the quick ratio provides a better picture by discounting inventory and other current assets. These are removed in the calculations as they are not easily converted into cash.
Quick Ratio= (Cash & Equivalents + Short term investments + Accounts Receivables)/ Current Liabilities

IBM’s Quick Ratio= $40.31 billion/ $39.6 billion =1.018

  1. Cash Ratio

This ratio further refines the quick ratio by removing receivables from the numerator. The reasoning behind this is that the receivables are not always provided on time. Hence a firm should have sufficient buffer in cash and cash equivalents to meet any immediate obligation.
Cash Ratio = (Cash + Cash Equivalents + Invested funds)/Current liabilities

IBM’s Cash Ratio= $8.47 billion/$39.6 billion=0.21

  1. Cash Conversion Cycle

This metric shows the number of days a firm takes in selling its inventory, collect receivables and finally complete its payables. The shorter this cycle is the lesser will be the stress of sales on company’s operations.

Cash conversion cycle= Days inventory outstanding + Days sales outstanding- Days payables outstanding

Here we subtract payables as it is beneficial for a firm to extend its payment terms giving it more access to cash.

Fig 5: IBM’s cash conversion cycle has improved in the recent years and shows a remarkable stability unlike previous years.

The Bottom Line

Besides these financial ratios there are others also which are useful in ratio analysis which measure other parameters like Profitability, Operating performance, Cash Flow and more. They are an integral part of financial analysis and a must for every discerning investor.

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