13.4. Analyzing Financial Statements with Ratios
Financial statements have lots of numbers in them. (Duh!) All these numbers can seem overwhelming when you're trying to see the big picture and make general conclusions about the financial performance and condition of the business. One very useful way to interpret financial reports is to compute ratios — that is, to divide a particular number in the financial report by another. Financial statement ratios are also useful because they enable you to compare a business's current performance with its past performance or with another business's performance, regardless of whether sales revenue or net income was bigger or smaller for the other years or the other business. In other words, using ratios cancels out size differences. (I bet you knew that, didn't you?)
Surprisingly, you don't find too many ratios in financial reports. Publicly owned businesses are required to report just one ratio (earnings per share, or EPS), and privately owned businesses generally don't report any ratios. Generally accepted accounting principles (GAAP) don't demand that any ratios be reported (except EPS for publicly owned companies). However, you still see and hear about ratios all the time, especially from stockbrokers and other financial professionals, so you should know what the ratios mean, even if you never go to the trouble of computing them yourself.
NOTE
Ratios do not provide final answers — they're helpful indicators, and that's it. For example, if you're in the market for a house, you may consider cost per square foot (the total cost divided by total square feet) as a way of comparing the prices of the houses you're looking at. But you have to put that ratio in context: Maybe one neighborhood is closer to public transportation than another, and maybe one house needs more repairs than another. In short, the ratio isn't the only factor in your decision.
Figures 13-1 and 13-2 present an income statement and balance sheet for a public business that will serve as the example for the rest of the chapter. I don't include a statement of cash flows here — because no ratios are calculated from data in this financial statement. (Well, I should say that no cash flow ratios have yet become widespread and commonly used; you could take data from the statement of cash flows and calculate ratios, of course.) I don't present the footnotes to the company's financial statements here, but I discuss reading footnotes in the upcoming section "Frolicking Through the Footnotes." The financial statements were audited by an independent CPA firm. (I tackle the nature of audits in Chapter 15, and later in this chapter, I explain why you should read the auditor's report — see "Checking for Ominous Skies in the Audit Report.")
Figure 13.1. Income statement example for a business.
Figure 13.2. Balance sheet example for a business.
13.4.1. Gross margin ratio
As I explain in Chapters 4 and 9, making bottom-line profit begins with making sales and earning sufficient gross margin from those sales. By sufficient, I mean that your gross margin must cover the expenses of making sales and operating the business, as well as paying interest and income tax expenses, so that there is still an adequate amount left over for profit. You calculate the gross margin ratio as follows:
Gross margin ÷ Sales revenue = Gross margin ratio
So a business with a $158.25 million gross margin and $457 million in sales revenue (refer to Figure 13-1) earns a 34.6 percent gross margin ratio. Now, suppose the business had been able to reduce its cost of goods sold expense and had earned a 35.6 percent gross margin. That one additional point (one point equals 1 percent) would have increased gross margin $4.57 million (1 percent × $457 million sales revenue) — which would have trickled down to earnings before income tax, assuming other expenses below the gross margin line had been the same (except income tax). Earnings before income tax would have been 9.3 percent higher:
$4,570,000 bump in gross margin ÷ $49,320,000 earnings before income tax = 9.3% increase
Never underestimate the impact of even a small improvement in the gross margin ratio!
Investors can track the gross margin ratios for the two or three years whose income statements are included in the annual financial report, but they really can't get behind gross margin numbers for the "inside story." In their financial reports, public companies include a management discussion and analysis (MD&A) section that should comment on any significant change in the gross margin ratio. But corporate managers have wide latitude in deciding what exactly to discuss and how much detail to go into. You definitely should read the MD&A section, but it may not provide all the answers you're looking for. You have to search further in stockbroker releases, in articles in the financial press, or at the next professional business meeting you attend.
As I explain in Chapter 9, business managers pay close attention to margin per unit and total margin in making and improving profit. Margin does not mean gross margin, but rather it refers to sales revenue minus product cost and all other variable operating expenses of a business. In other words, margin is profit before the company's total fixed operating expenses (and before interest and income tax). Margin is an extremely important factor in the profit performance of a business. Profit hinges directly on margin.
NOTE
The income statement in an external financial report discloses gross margin and operating profit, or earnings before interest and income tax expenses (see Figure 13-1 for instance). However, the expenses between these two profit lines in the income statement are not classified into variable and fixed. Therefore, businesses do not disclose margin information in their external financial reports — they wouldn't even think of doing so. This information is considered to be proprietary in nature; it is kept confidential and out of the hands of competitors. In short, investors do not have access to information about a business's margin or its fixed expenses. Neither GAAP nor the SEC requires that such information be disclosed — and it isn't! Nevertheless, stock analysts and investment pundits make the best estimates they can for the margins of businesses they analyze. But, they have to work with other information than what's in a company's financial report.
13.4.2. Profit ratio
Business is motivated by profit, so the profit ratio is very important, to say the least. The bottom line is not called the bottom line without good reason. The profit ratio indicates how much net income was earned on each $100 of sales revenue:
Net income ÷ Sales revenue = Profit ratio
The business in Figure 13-1 earned $32.47 million net income from its $457 million sales revenue, so its profit ratio equals 7.1 percent, meaning that the business earned $7.10 net income for each $100 of sales revenue. (Thus, its expenses were $92.90 per $100 of sales revenue.) Profit ratios vary widely from industry to industry. A 5 to 10 percent profit ratio is common in many industries, although some high-volume retailers, such as supermarkets, are satisfied with profit ratios around 1 or 2 percent.
NOTE
You can turn any ratio upside down and come up with a new way of looking at the same information. If you flip the profit ratio over to be sales revenue divided by net income, the result is the amount of sales revenue needed to make $1 profit. Using the same example, $457 million sales revenue – $32.47 million net income = 14.08, which means that the business needs $14.08 in sales to make $1.00 profit. So you can say that net income is 7.1 percent of sales revenue, or you can say that sales revenue is 14.08 times net income.
13.4.3. Earnings per share (EPS), basic and diluted
Publicly owned businesses, according to generally accepted accounting principles (GAAP), must report earnings per share (EPS) below the net income line in their income statements — giving EPS a certain distinction among ratios. Why is EPS considered so important? Because it gives investors a means of determining the amount the business earned on their stock share investments: EPS tells you how much net income the business earned for each stock share you own. The essential equation for EPS is as follows:
Net income ÷ Total number of capital stock shares = EPS
For the example in Figures 13-1 and 13-2, the company's $32.47 million net income is divided by the 8.5 million shares of stock the business has issued to compute its $3.82 EPS.
Note: EPS is extraordinarily important to the stockholders of businesses whose stock shares are publicly traded. These stockholders pay close attention to market price per share. They want the net income of the business to be communicated to them on a per share basis so that they can easily compare it with the market price of their stock shares. The stock shares of privately owned corporations are not actively traded, so there is no readily available market value for the stock shares. Private businesses do not have to report EPS according to GAAP. The thinking behind this exemption is that their stockholders do not focus on per share values and are more interested in the business's total net income.
The business in the example could be listed on the New York Stock Exchange (NYSE). Assume that its capital stock is being traded at $70 per share. The Big Board (as it is called) requires that the market cap (total value of the shares issued and outstanding) be at least $100 million and that it have at least 1.1 million shares available for trading. With 8.5 million shares trading at $70 per share, the company's market cap is $595 million, well above the NYSE's minimum. At the end of the year, this corporation has 8.5 million stock shares outstanding, which refers to the number of shares that have been issued and are owned by its stockholders. Thus, its EPS is $3.82, as just computed.
But here's a complication: The business is committed to issuing additional capital stock shares in the future for stock options that the company has granted to its executives, and it has borrowed money on the basis of debt instruments that give the lenders the right to convert the debt into its capital stock. Under terms of its management stock options and its convertible debt, the business may have to issue 500,000 additional capital stock shares in the future. Dividing net income by the number of shares outstanding plus the number of shares that could be issued in the future gives the following computation of EPS:
$32,470,000 net income ÷ 9,000,000 capital stock shares issued and potentially issuable = $3.61 EPS
This second computation, based on the higher number of stock shares, is called the diluted earnings per share. (Diluted means thinned out or spread over a larger number of shares.) The first computation, based on the number of stock shares actually issued and outstanding, is called basic earnings per share. Both are reported at the bottom of the income statement — see Figure 13-1.
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NOTE
Calculating basic and diluted EPS isn't always as simple as my example may suggest. Here are just two examples of complicating factors that require the accountant to adjust the EPS formula. During the year a company may
Issue additional stock shares and buy back some of its stock shares. (Shares of its stock owned by the business itself that are not formally cancelled are called treasury stock.) The weighted average number of outstanding stock shares is used in these situations.
Issue more than one class of stock, causing net income to be divided into two or more pools — one pool for each class of stock. EPS refers to the common stock, or the most junior of the classes of stock issued by a business. (Let's not get into tracking stocks here, when a business divides itself into two or more sub-businesses and you have an EPS for each sub-part of the business, because few public companies do this.)
13.4.4. Price/earnings (P/E) ratio
The price/earnings (P/E) ratio is another ratio that's of particular interest to investors in public businesses. The P/E ratio gives you an idea of how much you're paying in the current price for stock shares for each dollar of earnings (the net income being earned by the business). Remember that earnings prop up the market value of stock shares.
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The P/E ratio is calculated as follows:
Current market price of stock ÷ Most recent trailing
12 months diluted EPS* = P/E ratio* If the business has a simple capital structure and does not report a diluted EPS, its basic EPS is used for calculating its P/E ratio (see the previous section).
The capital stock shares of the business in our example are trading at $70, and its diluted EPS for the latest year is $3.61. Note: For the remainder of this section, I will use the term EPS; I assume you understand that it refers to diluted EPS for businesses with complex capital structures, or to basic EPS for businesses with simple capital structures.
Stock share prices of public companies bounce around day to day and are subject to big changes on short notice. To illustrate the P/E ratio, I use the $70 price, which is the closing price on the latest trading day in the stock market. This market price means that investors trading in the stock think that the shares are worth about 19 times EPS ($70 market price ÷ $3.61 EPS = 19). This P/E ratio should be compared with the average stock market P/E to gauge whether the business is selling above or below the market average.
Over the last century, average P/E ratios have fluctuated more than you might think. I remember when the average P/E ratio was less than 10, and a time when it was more than 20. Also, P/E ratios vary from business to business, industry to industry, and year to year. One dollar of EPS may command only a $12 market value for a mature business in a no-growth industry, whereas a dollar of EPS for dynamic businesses in high-growth industries may be rewarded with a $35 market value per dollar of earnings (net income).
13.4.5. Dividend yield
The dividend yield ratio tells investors how much cash income they're receiving on their stock investment in a business. Suppose that our business example paid $1.50 cash dividends per share over the last year, which is less than half of its EPS. (I should mention that the ratio of annual dividends per share divided by annual EPS is called the payout ratio.) You calculate the dividend yield ratio for this business as follows:
$1.50 annual cash dividend per share ÷ $70 current market price of stock = 2.1% dividend yield
You can compare the dividend yield with the interest rate on high-grade debt securities that pay interest. The average interest rate of high-grade debt securities (U.S. Treasury bonds and Treasury notes being the safest) is sometimes two or more times the dividend yields on public corporations. In theory, market price appreciation of the stock shares makes up for this gap. Of course, stockholders take the risk that the market value will not increase enough to make their total return on investment rate higher than a benchmark interest rate.
Assume that long-term U.S. Treasury bonds are paying 4.5 percent annual interest, which is 2.4 percent higher than the business's 2.1 percent dividend yield in the example. If this business's stock shares don't increase in value by at least 2.4 percent over the year, its investors would have been better off investing in the debt securities instead. (Of course, they wouldn't have gotten all the perks of a stock investment, like those heartfelt letters from the president and those glossy financial reports.) The market price of publicly traded debt securities can fall or rise, so things get a little tricky in this sort of investment analysis.
13.4.6. Book value and book value per share
NOTE
The amount reported in a business's balance sheet for owners' equity is called its book value. In the Figure 13-2 example, the book value of owners' equity is $217.72 million at the end of the year. This amount is the sum of the accounts that are kept for owners' equity, which fall into two basic types: capital accounts (for money invested by owners minus money returned to them), and retained earnings (profit earned and not distributed to the owners). Just like accounts for assets and liabilities, the entries in owners' equity accounts are for the actual, historical transactions of the business.
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Public companies have one advantage: You can easily determine the current market value of their ownership shares and the market cap for the business as a whole (equal to the number of shares × the market value per share.) The market values of capital stock shares of public companies are easy to find. Stock market prices are reported every trading day in many newspapers and on the Internet.
Private companies have one disadvantage: There is no active trading in their ownership shares to provide market value information. The shareowners of a private business probably have some idea of the price per share that they would be willing to sell their shares for, but until an actual buyer for their shares or for the business as a whole comes down the pike, market value is not known. Even so, in some situations there is a need to put a market value on the business and/or its ownership shares. For example, when a shareholder dies or gets a divorce there is need for a current market value estimate of the owner's shares (for estate tax or divorce settlement purposes). When making an offer to buy a private business, the buyer puts a value on the business, of course. The valuation of a private business is beyond the scope of this book. You can find more on this topic in a book I coauthored with my son, Tage C. Tracy, called Small Business Financial Management Kit For Dummies (Wiley).
One value of the ownership shares for both public and private businesses is book value per share. You calculate the book value per share for a business as follows:
Owners' equity ÷ Number of stock shares outstanding =
Book value per shareThe business shown in Figure 13-2 has issued 8.5 million capital stock shares. The book value of its $217.72 million owners' equity divided by the number of stock shares gives a book value per share of $25.61. If the business sold off its assets exactly for their book values and paid all its liabilities, it would end up with $217.72 million left for the stockholders, and it could therefore distribute $25.61 per share to them. But, of course, the company doesn't plan to go out of business, liquidate its assets, and pay off its liabilities anytime soon.
NOTE
Is book value the major determinant of market value? No, generally speaking book value is not the dominant factor that drives the market price of a stock — not for a public company whose stock shares are traded every day, nor for a private business when a value is being put on the business. EPS is much more important for public companies. However, let's not throw out the baby with the bathwater — book value per share is not entirely irrelevant. Book value per share is the measure of the recorded value of the company's assets less its liabilities — the net assets backing up the business's stock shares.
Book value per share is important for value investors, who pay as much attention to the balance sheet factors of a business as to its income statement factors. They search out companies with stock market prices that are not too much higher, or even lower, than book value per share. Part of their theory is that such a business has more assets to back up the current market price of its stock shares, compared with businesses that have relatively high market prices relative to their book value per share. In the example, the business's stock is selling for about 2.8 times its book value per share ($70 market price per share ÷ $25.61 book value per share = 2.8 times). This may be too high for some investors and would certainly give value investors pause before deciding to buy stock shares of the business.
Book value per share can be calculated for a private business, of course. But its capital stock shares are not publicly traded, so there is no market price to compare the book value per share with. Suppose I own 1,000 shares of stock of a private business, and I offer to sell 100 of my shares to you. The book value per share might play some role in our negotiations. However, a more critical factor would be the amount of dividends per share the business will pay in the future, which depends on its earnings prospects. Your main income would be dividends, at least until you had an opportunity to liquidate the shares (which is uncertain for a private business).
13.4.7. Return on equity (ROE) ratio
The return on equity (ROE) ratio tells you how much profit a business earned in comparison to the book value of its owners' equity. This ratio is especially useful for privately owned businesses, which have no easy way of determining the market value of owners' equity. ROE is also calculated for public corporations, but, just like book value per share, it generally plays a secondary role and is not the dominant factor driving market prices. Here's how you calculate this ratio:
Net income ÷ Owners' equity = ROE
The business whose income statement and balance sheet are shown in Figures 13-1 and 13-2 earned $32.47 million net income for the year just ended and has $217.72 million owners' equity at the end of the year. Therefore, its ROE is 14.9 percent:
$32,470,000 net income ÷ $217,720,000 owners' equity
= 14.9% ROENet income increases owners' equity, so it makes sense to express net income as the percentage of improvement in the owners' equity. In fact, this is exactly how Warren Buffett does it in his annual letter to the stockholders of Berkshire Hathaway. Over the 42 years ending in 2006, Berkshire Hathaway's average annual ROE was 21.4 percent, which is extraordinary. See the sidebar "If you had invested $1,000 in Berkshire Hathaway in 1965."
13.4.8. Current ratio
The current ratio is a test of a business's short-term solvency — its capability to pay its liabilities that come due in the near future (up to one year). The ratio is a rough indicator of whether cash on hand plus the cash to be collected from accounts receivable and from selling inventory will be enough to pay off the liabilities that will come due in the next period.
As you can imagine, lenders are particularly keen on punching in the numbers to calculate the current ratio. Here's how they do it:
Current assets ÷ Current liabilities = Current ratio
Note: Unlike most other financial ratios, you don't multiply the result of this equation by 100 and represent it as a percentage.
Businesses are generally expected to maintain a minimum 2 to 1 current ratio, which means its current assets should be twice its current liabilities. In fact, a business may be legally required to stay above a minimum current ratio as stipulated in its contracts with lenders. The business in Figure 13-2 has $136,650,000 in current assets and $58,855,000 in current liabilities, so its current ratio is 2.3. It shouldn't have to worry about lenders coming by in the middle of the night to break its legs. Chapter 5 discusses current assets and current liabilities and how they are reported in the balance sheet.
13.4.9. Acid-test ratio
Most serious investors and lenders don't stop with the current ratio for testing the business's short-term solvency (its capability to pay the liabilities that will come due in the short term). Investors, and especially lenders, calculate the acid-test ratio — also known as the quick ratio or the pounce ratio — which is a more severe test of a business's solvency than the current ratio. The acid-test ratio excludes inventory and prepaid expenses, which the current ratio includes, and it limits assets to cash and items that the business can quickly convert to cash. This limited category of assets is known as quick or liquid assets.
You calculate the acid-test ratio as follows:
Liquid assets ÷ Current liabilities = Acid-test ratio
Note: Like the current ratio, you don't multiply the result of this equation by 100 and represent it as a percentage.
The business example in Figure 13-2 has two "quick" assets: $14.85 million cash and $42.5 million accounts receivable, for a total of $57.35 million. (If it had any short-term marketable securities, this asset would be included in its total quick assets.) Total quick assets are divided by current liabilities to determine the company's acid-test ratio, as follows:
$57,350,000 quick assets ÷ $58,855,000 current
liabilities = .97 acid-test ratioIts .97 to 1.00 acid-test ratio means that the business would be just about able to pay off its short-term liabilities from its cash on hand plus collection of its accounts receivable. The general rule is that the acid-test ratio should be at least 1.0, which means that liquid (quick) assets should equal current liabilities. Of course, falling below 1.0 doesn't mean that the business is on the verge of bankruptcy, but if the ratio falls as low as 0.5, that may be cause for alarm.
NOTE
This ratio is also known as the pounce ratio to emphasize that you're calculating for a worst-case scenario, where a pack of wolves (known as creditors) could pounce on the business and demand quick payment of the business's liabilities. But don't panic. Short-term creditors do not have the right to demand immediate payment, except under unusual circumstances. This ratio is a very conservative way to look at a business's capability to pay its short-term liabilities — too conservative in most cases.
13.4.10. Return on assets (ROA) ratio and financial leverage gain
As I discuss in Chapter 5, one factor affecting the bottom-line profit of a business is whether it uses debt to its advantage. For the year, a business may realize a financial leverage gain, meaning it earns more profit on the money it has borrowed than the interest paid for the use of that borrowed money. A good part of a business's net income for the year could be due to financial leverage.
The first step in determining financial leverage gain is to calculate a business's return on assets (ROA) ratio, which is the ratio of EBIT (earnings before interest and income tax) to the total capital invested in operating assets. Here's how to calculate ROA:
EBIT ÷ Net operating assets = ROA
Note: This equation uses net operating assets, which equals total assets less the non-interest-bearing operating liabilities of the business. Actually, many stock analysts and investors use the total assets figure because deducting all the non-interest-bearing operating liabilities from total assets to determine net operating assets is, quite frankly, a nuisance. But I strongly recommend using net operating assets because that's the total amount of capital raised from debt and equity.
Compare ROA with the interest rate: If a business's ROA is, say, 14 percent and the interest rate on its debt is, say, 6 percent, the business's net gain on its debt capital is 8 percent more than what it's paying in interest. There's a favorable spread of 8 points (one point = 1 percent), which can be multiplied times the total debt of the business to determine how much of its earnings before income tax is traceable to financial leverage gain.
In Figure 13-2, notice that the business has $100 million total interest-bearing debt: $40 million short-term plus $60 million long-term. Its total owners' equity is $217.72 million. So its net operating assets total is $317.72 million (which excludes the three short-term non-interest-bearing operating liabilities). The company's ROA, therefore, is:
$55,570,000 EBIT ÷ $317,720,000 net operating assets
= 17.5% ROAThe business earned $17.5 million (rounded) on its total debt — 17.5 percent ROA times $100 million total debt. The business paid only $6.25 million interest on its debt. So the business had $11.25 million financial leverage gain before income tax ($17.5 million less $6.25 million).
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