- Ratio analysis is an important part of fundamental analysis
- It helps to measure the performance of a company and also compare the same to that of its peers.
- Understanding the financial ratios for gauging profitability, operational performance and cash flow is critical.
Ratio analysis is used to find how well a particular firm is being run and its efficiency vis-à-vis its peers in the industry. We look at profitability, Cash Flow and operating performance ratios to ascertain the performance of the firms. Financial ratio analysis helps in making comparison easier and in turn provides valuable information to find an ideal valuation for a firm.
Profit is the core reason for the existence of any firm. The profit earning ability gives an indication about the ability of the firm to survive economic upheavals and also provide good benefits to the shareholders.
By looking at the profit for the past couple of years one can quickly summarize the effectiveness of a company’s management. However instead of looking at the profit alone one needs to look at profit margin to get a complete knowledge. There are four major types of profit margins:
- Gross Profit margin: Gross profit/ Total Revenue
- Operating Profit Margin: Operating Profit/ Total Revenue
- Pretax Profit Margin: Pretax Profit/ Total Revenue
- Net Profit Margin: Net Income/ Total Revenue
These are four different levels at which the functioning of a firm is gauged. A firm having good gross profit margin but poor operating profit margin would mean that the operating expenses like SG&A expenses are very high and need to be reined in. Similarly a high operating margin and a low pretax profit margin shows high interest expense. Using these margins one can quickly find any major weak points within a firm’s performance.
We can compare these numbers by glancing at the figures of IBM (NYSE:IBM) for the past couple of years:
This shows that the company is performing fairly well. It was able to increase its gross margins from mid 40s to 50% and its operating margin is also stable. In the last year the net profit margin fell sharply which can be attributed to a sudden spike in tax outgo from 15.58% in 2013 to 21.19% in 2014. The company also took a hit of $3.8 billion by selling loss making units. If there are any sudden changes in margins, a closer analysis of the financial statements is required.
A younger company generally has higher margins and as the company matures the margins stabilize at a lower level. Across industries also there is a huge difference. For example, utility and consumer goods companies have much lower margins than the technology industry.
The above chart shows the Gross Profit Margin and Operating Profit Margin for Google (NASDAQ:GOOGL). There is a noticeable dip in operating margin from mid 30’s to mid 20’s in the past couple of years owing to higher SG&A and R&D expenses required by a bigger organization.
Return on Assets
This shows the ability of the management to employ the assets of a firm in a profitable manner. A higher ROA compared with peers would mean a greater bang for every buck which the company holds in assets.
The denominator is the average of the beginning and end of the year asset values. This averaging is required because a firm might dispose an asset or purchase another firm which would alter the denominator.
ROA also varies considerably across industries. For manufacturing companies like General Electric (NYSE:GE) this is 2.33% owing to a higher asset base whereas Microsoft (NASDAQ:MSFT) which has a much smaller need for assets has a higher ROA of 14.02%.
The ROA’s for different sectors is generally very different. In Fig 3, we can see GE at the bottom end, FMCG companies in the middle and technology companies at the higher end due to lower requirement for assets.
Return on Equity Ratio (ROE)
In case the company has preferred stock there is a slight variation to this formula. The preferred dividends will be subtracted from the net income and similarly in the denominator we will remove the amount of preferred stock.
- Return on Capital Employed (ROCE)
For ROCE calculation, instead of looking at the shareholder equity alone, returns made on the total capital employed, including equity and debt, is considered. Many firms use higher levels of debt which substitutes equity in helping them generate returns. This higher financial leverage can be problem if taken in excess. ROCE gives a truer picture of the total returns on all the investment used by the management.
ROCE: Net Income/ (Average debt + Average shareholder Equity)
Ratios of Operating Performance
Fixed Asset Turnover
This ratio shows the ability of a firm to use its fixed assets to generate sales. This ratio also varies greatly in different industries and is particularly high for technology firms as they require lesser investment in fixed assets against manufacturing companies like Boeing and GE. Here fixed assets mean the investment in Property, Plant and Equipment (PP&E)
Revenue per Employee
This number shows the dollars earned per employee within a firm. Across industries this ratio might vary owing to the level of labor intensive operations required. However it is a good tool for peer comparison and looking at the operational effectiveness of firms over a span of 5-10 years.
Fig 4 shows the revenue per employee of different tech majors. Google leads this pack whereas IBM which is more service oriented is able to pull lesser revenue per employee. Within the tech sector, employee cost is the major input cost for a company and hence effective use of these employees should help the company in earning better margins.
This is an indicator of the effectiveness of a management in managing the operations of the firm. This is also known as cash conversion cycle (CCC).
Operating Cycle (In days) = DIO + DSO- DPO
DIO-> Days inventory outstanding
DSO-> Days Sales outstanding
DPO-> Days Payables outstanding
For Amazon the same figures can be seen from Fig 5. DSO+DIO-DPO for the recent quarter is 34.4+15.5-59.5=-9.6 days. The operating cycle is favorable for most of the period in the past ten years. However, Amazon’s ability to keep its creditors at bay has plateaued over the last four years.
Cash Flow Indicators
Through the use of accounting shenanigans and other tricks the management can overstate their performance or tone down any negative news which might come out. However cash flow is an indicator which is difficult to play around with. Many analysts keep a close eye on how the cash flow is impacted vis-à-vis other parameters which the firm comes out with. Huge diversions between these can be an early warning sign about difficulties within the firm.
Operating Cash Flow/ Sales ratio
An increase in sales needs to show a similar increase in operating cash flow. If there is any divergence between these two it will show in the changes in the sales terms used by the firm. A stable ratio shows that the firm is increasing the operating cash flow in line with its sales.
Free Cash Flow/ Operating cash flow ratio
Free cash flow is the final cash available after deducting any capital expenses from the operating cash flow. This is also one of the favorite metrics for value investors like Buffett who has gone on record several times showing his liking for firms which produce consistent free cash flow for long durations. This was also one of the biggest reasons for Buffett's investment in IBM for his first ever foray into the technology sector.
Cash Flow Coverage Ratios
A company should be able to fulfill its short term debt and other obligations through its operating cash flow (OCF). A number of ratios help to find if the firm is producing enough operating cash flow.
- Short term debt coverage ratio: Operating Cash Flow/ Short term debt
- Capital Expenditure (Capex) coverage: OCF/ Capex
- Dividend coverage: OCF/Cash Dividends
Fig 6: The dividend cover for three tech majors is compared. A rule of thumb is that the dividend cover should be at least 1.6. This ensures the company retains judicious levels of cash for future expansion.
These ratios are important when comparing with peers to know the ideal coverage required within the industry.
- Dividend Payout Ratio:
This ratio gives the percentage of income returned to the shareholders through dividend.
Mature firms can have a dividend ratio as high as 60-70%. However tech industry is known for lower dividend payout as the firms keep the earnings for future expansion.
These ratios are the backbone of financial analysis and provide an unbiased view of the performance of a company in comparison to its peers. At the same time deeper analysis is required in case there is sudden divergence which might be due to non-continuous operations.
For detailed understanding of valuation, debt, liquidity and other financial ratios, please see Financial Ratio Analysis For Dummies: Part 1