In Statement Analysis, a firm’s statements are analyzed to help decide whether the firm’s stock is over- or under-valued. Ratios are used to express relations of statement items and compared to benchmarks or peers.
The Statement Analysis ratios are grouped by the aspect which is being measured. The groups are
- liquidity
- activity
- profitability
- leverage.
After the ratios are figured, they are used to value the firm’s share price.
Ratio Analysis
Ratios are the most used tool to compare a firm because they are easy to understand and can be computed with ease. In addition, the info is easy to obtain and used by you and the firm.
The ratios are used to perceive trends in a time series or comparing peers in cross section studies. Also, certain ratios are more key to certain industries than others. The financial and utility sectors use other ratio sets than other sectors.
One ratio by itself doesn’t tell you much, but several ratios will give you a good idea on strengths and weaknesses. Rarely, all the ratios show the same picture. Ratios ares one of the ways SCM measures leader’s merit.
Liquidity Ratios
Liquidity is the ease in which a firm can convert their assets to cash. Thus, a highly liquid firm can pay their bills with loss. Liquidity ratios are useful to creditors who are concerned about getting paid on a timely basis.
The most liquid assets are measured with current ratio. It is calculated by dividing the current assets by the current liabilities. In most industries, it is desirable to have more current assets than liabilities but this rule of thumb doesn’t apply to all.
The quick ratio factors out inventory and is a key measure of working capital. This more liquid capital is easier to obtain than having to manufacture goods from stock of raw materials. Taken together, these ratios are helpful in analyzing firms with large inventories.
Activity Ratios
Activity ratios indicate the rate a firm is turning its inventory and A/R into cash. High turnover signals it is in better position to handle debt but does not mean maxing profits.
Inventory turnover is derived by dividing sales by average inventory for a given period. Higher turnover reduces costs. Alternatively, cost of goods sold can replace sales which maybe needed to focus on the ease of covering costs.
Average collection period and receivable turnover are ways of measuring the leader’s chops. It is tough for you to obtain some of these data points because they are only published on a yearly basis and could mislead a firm’s sales or any growth.
Profitability Ratios
The amount a firm earns is most key to investors. Earnings accrue to you and fuel payouts. Retained earnings represent additional investment of the corporation. Profitability ratios are a set of ratios which pertain to the firm’s ability to grow earnings and pay dividends.
They measure earnings relative to some base such as sales assets and or equity. Also, the gross margin is cost of goods sold subtracted from revenues divided by revenues It only looks at the core business and ignores how the firm is financed.
The net margin takes into consideration everything: taxes, depreciation and interest paid. The return on assets ratio shows how well management is utilizing their assets. Return on equity shows how profitable they are relative to the shareholder’s stake.
Leverage Ratios
Financial leverage ratios indicate how the firm can lever your funds using debt. Because debt can have a large impact on the firm, these ratios are key in learning the risk of the firm’s status.
The most common leverage ratios are debt to equity and debt to total assets. The former is figured by dividing debt by equity. The latter is derived by dividing debt by total assets. Either way, each is OK.
These measures are totals and don’t note short-term and long-term. Thus, theory suggests there is an perfect combo of debt and equity which maxes the value of the firm. You will invest your funds with a large amount of debt to boost your share.
Ratio Analysis
You don’t need a ton of Statement Analysis ratios to get a good idea of a firm’s status. Also, your area of focus differs from a creditor in they are more worried about the chance to get paid.
Profits are more key to you with measures such as earnings, growth in earnings and market’ values of the stock. Also, the key is how the firm grows from the inside.
Reasoned thinking of the ratios is key to our picks. Also, if a ratio doesn’t match a benchmark or the firms being compared have slightly different markets, judgement is key.
Statement Analysis Values
There can be gaps in ratios from year to year or things can remain stable. Also, if there is a gap from benchmarks or from peers, we must ask why. It might be a not repeat item and can be ignored or it could be the start of a trend with bad omens.
The ratios may not help with our picks due to the ratios being based on past data and not point to the future. Also, even if past results is repeated, you have to have an idea of the firm’s worth.
Also, visit these topics for further detail or return to the Basics page:
The info n this Statement section and other Basics sections were from Dave’s lecture notes for the Investments for Pros course taught at UCLA 1998-2005 and three decades on the job. Also, see our Site Credits page for Statement sources.
