Analyzing financial ratios can be overwhelming at first.
How do you start? Which financial ratios are the most important? What formulas should you be using?
All of these questions run through your head and stop you from getting started. But what if you had a process for ratio analysis that made analyzing these metrics more simple?
Well now you do.
This 5 step framework is going to help you be efficient in analyzing financial ratios and jump starting your ratio analysis.
This framework will help you organize your thoughts and better prioritize the steps necessary to efficiently and effectively analyze financial statement ratios, and give you an edge on your competition.
In this post, we’ll quickly cover the basics of financial ratios, as well as the different types of ratios, and then jump right into the 5 step framework to mastering ratio analysis.
Let’s get going!
What is Ratio Analysis?
Financial ratio analysis is an analysis of key company metrics and information contained in a company’s financial statements.
Financial ratios include multiple parts of a company’s financial statements, and one of the main benefits of utilizing financial ratios in your analysis is that it allows you to compare those metrics against a different company, which otherwise may not be comparable.
Financial ratios are used to evaluate various aspects of a company’s operating and financial performance such as its liquidity, asset management, leverage, profitability and valuation.
Types of Ratio Analysis
The first step to a full analysis of a company’s financial statements begins with understanding the different types of ratios.
Liquidity ratios are used to assess a company’s ability to meet its short-term obligations using its short-term assets.
You can find the information to calculate these ratios under the current assets and current liabilities sub-headings on a company’s balance sheet.
By definition, an asset or liability is current if it’s expected to be converted into cash (asset), or is due to a creditor (liability) within one year of the financial statement date.
There are three important liquidity ratios that generally stand above the rest:
- Current Ratio = Current Assets / Current Liabilities
- Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
- Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
Using these ratios in your financial analysis will help you identify whether a company is cash-strapped or well positioned to pay back amounts borrowed and still have enough to re-invest in growing the company.
Both traits of highly successful companies!
Asset management ratios, or as some of you may refer to them, efficiency ratios, are important to understanding if a company’s management team is effectively using the company’s assets to generate sales.
There are five asset management ratios you should be very familiar with when analyzing a company’s financial statements:
- Accounts Receivable Turnover = Net Annual Credit Sales / Average Accounts Receivable
- Inventory Turnover = Cost of Goods Sold / Average Inventory
- Cash Conversion Cycle = Inventory Processing Days + Average Collection Period - Payables Payment Period
- Fixed Asset Turnover = Sales / Average Net Fixed Assets
- Asset Turnover Ratio = Sales / Average Total Assets
Knowing a company’s asset management ratios will give you a better idea of how a company is managing its capital, and whether they are efficiently turning their assets into earnings for the company’s shareholders.
Strong companies utilize their assets to create additional cash flow and revenue for their business to reinvest and redeploy back into operating activities. If a company has too much of their capital tied up in assets, this can lead to shortfalls in operating cash flow, but if they have too few, or low performing assets, this can lead to low returns on investment.
Leverage ratios, or debt management ratios, measure how much capital a company is utilizing comes in the form of debt (loans), and also analyzes the ability of a company to meet its required debt payments.
It’s important to understand leverage ratios given a company can rely on a mixture of equity and debt to finance its operations. Knowing the amount of loans held by a company allows us to evaluate whether the company we are analyzing can pay off its debts as they come due.
When a company has a strong management team and they are deploying capital as efficiently and strategically as possible, debt can be used as a catalyst for growth.
There are three main ratios that are broadly used by investors to analyze a company’s debt management:
- Debt Ratio = Total Debt / Total Assets
- Debt to Equity = Total Debt / Total Equity
- Interest Coverage = EBIT / Interest Expense
You can also calculate the weighted average cost of capital (WACC) to find the rate that a company is expected to pay investors and creditors to finance its assets.
Our goal is to find companies to invest in that are well position to pay off their debt, and also using that borrowed money to grow.
What we don’t want to see is a company that is spread too thin and heavily leveraged, where they are using debt as a bridge to make payments on other obligations.
Borrowing from one lender to pay another lender is not a trait of a well managed and well positioned company!
Analyzing leverage ratios is a key step in effective financial analysis and fundamental analysis.
Profitability ratios are what I like to call the “sexy” category of financial statement ratios because they are easy to understand, and they are usually the metrics analysts point to first when reporting on a stock.
And It makes sense that these ratios get a lot of attention.
Profitability ratios measure a key financial concept that we can all understand - is the company making money, or losing money.
A company could have great products, impressive management, and be well capitalized for future growth, but if they aren’t making money on their products, that company’s future starts looking pretty bleak.
There are five key profitability ratios that all stock gurus must understand before investing in a company’s stock:
- Gross Profit Margin = (Sales - Cost of Goods Sold) / Sales
- Operating Profit Margin = EBIT / Sales
- Net Profit Margin = Net Income / Sales
- Return on Assets = (Net Income + Interest Expenses) / Average Total Assets
- Return on Equity = Net Income / Average Common Equity
With profitability metrics, you can’t hide behind growing revenues, but increasing costs.
Strong profitability metrics mean a company is growing revenue, while controlling costs and generating net income.
I think of valuation ratios as an investor’s last line of defense.
These ratios evaluate how the rest of the market is valuing a stock relative to a measure of the company’s fundamentals.
Typically the valuation is compared to earnings, book value, cash flows, and dividends, but several other company fundamentals could be used.
For now, we’ll focus on four valuation ratios:
- Price to Earnings = Market Price Per Share / Earnings Per Share
- Price to Book Value = Market Price Per Share / Book Value Per Share
- Price to Cash Flow = Market Price Per Share / Cash Flow Per Share
- Dividend Yield = (Dividend Per Share**** x 100) / Market Price Per Share
Valuation ratios are critical to understanding whether a stock is priced below its market value.
Analyzing liquidity ratios, asset management ratios, leverage ratios and profitability ratios may indicate a company is hitting on all cylinders, but if the valuation ratios indicate that the company’s stock price is too high, this could be a signal that you shouldn’t invest.
So what’s the point?
At this point you may be thinking:
“alright... I understand financial ratios, as well as the different families of ratios, but that doesn’t do me much good if I don’t know what it all means.”
If you were thinking this... then I am telepathic, and you would also be right!
Financial ratios are just numbers on a page without further understanding and analyzing what they actually mean to a company and what that tells you about whether they are in good position to grow.
But don’t worry, we’re pressing on in our ratio analysis joy ride, and the next stop is taking a look at the 5 step process for discovering whether a company’s financial ratios are trending in the right direction and how it stacks up to their industry group.
The 5 Step Framework for Interpreting a Company’s Financial Ratios
We’re diving into the 5 step framework for effectively analyzing and interpreting a company’s financial statement ratios, and what better place to start than with the company itself.
1. Where to begin? Start with the company’s trends
The first step in your analysis is to see what you can learn from the historical results of the Company.
Public companies are required to disclose their financial results to investors on a quarterly basis (Form 10-Q, which is a more limited Filing than the annual report), as well as on an annual basis within their Form 10-K filed with the SEC. If you’re interested in learning more about the filing requirements of public companies, check out the SEC’s Website for everything you need to know.
Because of how frequently, and how much information is required to be reported by publicly traded companies, there is a lot of data out there that you can use to get an edge over your competition.
Once you know where a company currently stands, you can use this information to evaluate whether there are positive or negative historical trends that could impact the future results of the company.
Knowing where a company has been can tell us a lot about where they may be heading!
Let's say we are analyzing Apple Inc. (AAPL), and we’re looking at their current ratio.
I always like to evaluate trends in graph-form, which seems to provide better insights than looking at 10 years of static numbers (plus, it’s just easier on the eyes).
Let’s take a look at Apple’s trend since 2007 and see what the numbers tell us:
We can see from the chart that Apple’s current ratio has dipped when comparing it to several years ago (2008 and 2009, especially), but remains relatively consistent with a slight trend upwards from 2014 to 2017.
Hmm… this triggers a few questions…
Does this indicate Apple is on the downward trend? Or that Apple isn’t managing it’s liquidity as well as it once did?
To investigate this further, we can look at the company’s balance sheet to see if there is anything that jumps out as being the reason for the decrease in Apple’s current ratio over the last 10 years.
Would you look at that - on a macro level, we can tell right away that Apple has changed as a company since its early growth days in 2008 (current assets have quadrupled!), which means that a change in financial ratios isn’t out of the ordinary.
We can also see that accounts payable and accrued expenses are a much larger percentage of the balance sheet when compared to previous years, and those balances continue to trend upward.
It would require more analysis to further evaluate whether the increase in accounts payable and accrued expenses is something that should concern you, but overall, analyzing the trends of the company’s current ratio, and following the numbers to spot the cause of the changes, gives us a good start to understanding how Apple is performing.
It’s important to follow where the numbers take you, until you feel like you have a solid understanding of what accounts are trending upwards, or downwards, and what that means to the company as a whole.
Now that we've got the history… What’s next?
As you can see, there is a lot to be learned from evaluating the trends and data within a company’s historical results.
But looking at a company’s historical results alone isn’t enough to get the full story.
What if you identify a company that has improved their ratios year-over-year, only to find out that the only reason they were showing strong growth was because they had a very low ratio to begin with?
You could end up making a bad decision based on incomplete data, and at DiscoverCI we don’t like making bad decisions… or incomplete data…
In order to make sure you drawing the correct conclusions from analyzing the trends of a company, its important to understand more about the company’s operations and how they stack up against their competitors.
So how you take your financial analysis to the next level and identify whether there is more to the story than what can be told by looking at one company’s financial statements alone?
It’s time to level up and introduce the power of industry and sector data in our analysis.
2. Leveling Up: Identify the Company’s Industry and Sector
The next 4 steps of our analysis will include the use of industry and sector data, so what is that makes this data so important?
Each industry (and in some cases each company), face different risks, capital requirements, acceptable margins, valuation multiples, etc… which can make comparing companies across industries difficult.
For example, Facebook (FB) reported Gross Profit Margin of about 87% for 2017 (whoa, that’s high), while Amazon’s (AMZN) Gross Profit Margin was about 24% during the same period.
What the heck. What was all that talk about Amazon being a solid, fast growing, well managed company? That Profit Margin looks pretty weak when you compare it to Facebook!
Well, the truth is, what everyone says about Amazon remains true, but comparing their Gross Profit Margin to Facebook’s wouldn’t be a level playing field because they are very different companies.
Think about it this way, the cost of Facebook to provide their core offering - advertising - is a lot less than Amazon’s cost of selling you a $10 bottle of shampoo. The difference being, Amazon is selling a physical product, where Facebook is selling their services/access to their audience.
The end result - margins are higher on every dollar that Facebook earns, compared to every dollar that Amazon earns, which you can clearly see my analyzing their Gross Profit Margin.
The different product offerings makes for a bad comparison between these two companies.
Financial ratios allow you to compare the operating metrics of different companies, which otherwise may not be comparable. But not all companies are built the same, and not all ratios are comparable from one company to another.
The goal of identifying and grouping companies within a sector or industry during your analysis is to accurately compare and benchmark the company you are analyzing against a comparative peer group.
If you don’t get this part of your analysis right, it can lead to some misinterpretations down the road. And when it comes to making smart business and investment decisions, misinterpretations can be costly!
Now we know why industry data is important…
Armed with the ratio we calculated in step 1, and the knowledge we gained from reviewing the company’s historical results, it’s time to begin the process of measuring how the company stacks up to its peers.
Where to begin:
Measuring a company against its peers may seem like a daunting task.
What industry does the company compete in? How do I know the peers of a company? Where do I get the information I need to calculate the industry metrics? How do I interpret the information?
All good questions.
And here is some good news…
We’re about to come through with the answers.
Finding the Industry and Sector of a Company
You may know the general product offerings of a company, but do you know where they fit into industry data?
Industry and Sector data can be broken down in a various ways, and there are several different indexes that group companies differently.
So where do you start?
SIC and Industry Codes
Every public company is required to report their Standard Industrial Classification Code, or “SIC” Code, within their annual report (Form 10-K). You can check out a full list of reported sectors on the here.
A Company’s SIC code can be a helpful launching point when you are looking to identify what industry a company is in, and start building up a peer group.
The SIC codes are grouped by general categories that each contain smaller sub-categories.
The sub-categories typically provide a fairly focused and accurate sector of a company, and the company groupings are fairly small.
As a bonus, the SIC code is generally very reliable information as the classification comes from the company itself, and it’s a regulated disclosure by the SEC.
If after further evaluating the SIC code, and taking a look at the other companies who are included within the SIC code you determine that more data is needed to better understand the industry, you can find additional information using an advanced stock screener, or by tracking down a company’s NAICS Code (North American Industry Classification System).
A good stock screener (like the one within the DiscoverCI Platform), will allow you to search for a company within more general industry classifications, which can further help you define the industry and sector of a company.
Now that you know the industry of a company, you can take the next step by gaining a better understanding of a company’s operations.
3. Understand the Nature of the Company’s Operations
How do you take your competitor benchmarking from good to great? Dig into the underlying data of the company’s industry competitors.
To further enhance your analysis, you should segment the companies you are benchmarking by key operating traits, which would impact the operations and comparability of the companies.
The first to place to start when you’re looking for companies with similar operating characteristics, is to make sure you’ve done your homework on the company you are analyzing.
Each industry and company is unique, so you’ll need to spend some time thinking about what operating characteristics are important to the industry and company you are evaluating, but there are a few traits that are generally important to most companies.
The world is getting smaller, and more and more companies are growing their international operations, but there still could be significant differences that could impact your analysis between, say, a company headquartered in the United States, versus a company headquartered in China.
Each country has different laws and regulations, which can impact a company’s operating results. They can also be impacted by factors that are more unpredictable, such as exchange rates.
Identifying whether a company has a similar customer base is important to effectively benchmarking one company to another. Two companies operating within the same industry could have very different customer profiles.
One company may target people over 50 with a product, while a similar company may be targeting the teenager demographic.
These companies may be similar in several ways, but it’s important to understand how the different customer profiles could impact future operating results. Teenagers are generally less committed to one brand, while the older generation may be a very loyal customer base.
Knowing who a company is selling to can be the difference between a successful, or unsuccessful analysis.
Life cycle of the company
Company’s grow, and generally become more stable in their old age. Start-up companies are known for being disruptive - volatile growth rates, quick product innovations, and less “red-tape” are staples of young companies.
However, as a company grows and expands its operations, it becomes more difficult to maintain the start-up culture. Companies also reach a certain size where growth becomes harder to maintain, and making the needle move requires a bigger and bigger investment.
Because of the impact a company’s age has on its operating results, knowing where a company is at in its life-cycle can be a differentiator between you and the rest of the field.
You are now one with nature
As you can see - financial ratio analysis is more than just calculations and the numbers of a company. Knowing the key drivers of a company’s operations can lead to big insights when identifying a peer group and completing your financial analysis.
Once you’re clear on the nature and key characteristics of a company, you can use this information to identify a solid peer group for benchmarking.
4. Define the Company’s Industry and Peer Group
Once you are comfortable that you have a full understanding of the company’s trends, industry and key operating characteristics, its time to find a solid list of companies for benchmarking.
You can start by evaluating the other companies who report the same SIC code as the company you are evaluating.
We already discussed how these codes are determined, so you know that the other companies within the category will be at least generally comparative, but is that good enough?
In some cases, the answer could be... Yes - comparing a company’s financial ratios to the other companies within its SIC code is good enough, but most of time more work is required.
Within one SIC code there may be companies that are in significantly different stages of their operating history.
Apple reported its SIC classification as “Electronic Computers ” in its 2017 annual report.
I did a quick screen for companies within this Sector that reported revenue and assets of over $10 million in their most recent annual report, which returned 10 companies meeting this criteria. Within this group of companies there are companies with assets ranging from $20 million to over $375 billion:
Would a company with $20 million in assets be comparable to a company with $375 billion in total assets?
Asset size is generally a good indicator of the extent of a company’s operations, and comparing one company with a very small footprint to another company with a large footprint could lead to a skewed interpretation of the data.
Knowing how a company stacks up against its peers within an SIC or industry code only gives us a general feel for how the company is operating relative to its peers, but more can be gained by doing a deeper dive into the operations of the companies making up that SIC Code, and only including only the most relevant companies in your analysis.
Based on the work performed in steps 1 through 3, you should have a deep understanding of the company you are analyzing, which provides all of the information you need to take what you know, and identify a solid competitor group.
With the help of a stock screener, you can enhance your search for competitors based on key characteristics quickly, which is a big improvement over tracking down this information manually!
The key to accurately identifying a peer group and benchmarking a company’s ratios against that peer group is to leverage what you know about the company.
The peer group used in your analysis doesn’t always need to be carbon-copies of the company you are evaluating, but know why the companies within the peer group are similar, or different, will allow you to accurately interpret what the different ratios mean to your analysis.
Alright… we’ve made it to step 5! What a journey. Personally, I’m sad knowing that it’s coming to an end, but let’s press on.
Now that the hard work is done, the real fun can begin as we take all of the data and knowledge we’ve collected over the previous three steps and use it to interpret how the company is performing.
5. Determine How the Company Measures Up
At this point you have the company’s ratios, a good understanding of how the ratios are trending over time, knowledge of the nature of the company’s operations, and a list of companies that are comparable to the company you are evaluating.
Interpreting financial ratios is part science and part art.
The science is found in the numbers, which can clearly tell you whether a company’s ratios are higher, lower, or the same when compared to its competitors.
But the art of financial ratio analysis is what separates the good investors from the great investors. Being able to not only identify and compare the ratios, but interpret the information and what that will mean to the future operating results of a company is where analyzing financial ratios really provides the most bang for its buck.
From this point, it’s only a matter of reviewing the ratios and seeing where the company lands and what conclusions you can draw using the information in front of you.
Financial ratios are inter-related and knowing how interpreting one ratio to better understand a different ratio can lead to discovering important insights on company operating results and potential for future growth.
We’ll cover the concept of how financial ratios are inter-related more in future posts, but for now, you are one step ahead of your competitors.
Our Path to Mastering Financial Ratio Analysis
We’re off and running on our journey through financial ratio analysis.
This 5 step framework for analyzing and interpreting financial ratios provides the pillars of effectively evaluating a company’s operating results and you are well on your way to company intelligence and understanding the critical metrics of a company.
But there’s always more to uncover!
Keep at it and send us an email if you’d like to chat about anything that was covered in this post, and be sure to check out the best collection of financial ratio calculators on the web to help in your analysis here and subscribe to our email list to become a member of the DiscoverCI Community.