Using ratios to get more from a financial statement
Reading a company’s financial report to assess its state of health isn’t a very difficult thing to do. But, as with most things in life that are worth doing, some learning is necessary to get the most from it.
Learn your way around a financial statement
The fundamentals of the financial world are (fundamentally) straightforward. But they are all too often shrouded in jargon that prevents the lay person - including business professionals who don’t have a background in accounting - from properly understanding what they mean.
If you don’t know what to look for, you can all too easily jump to the wrong conclusions. For example, an increase in sales is only good news if the company has got its operating margins right. If they do not, more sales can actually mean shrinking profits.
Second, to get the big picture straightaway, don’t confuse yourself by trying to take in everything that’s in the report. The metrics that really matter are the balance sheet, the income statement and the cash flow statement. That’s because good, strong companies almost always tend to have a healthy balance sheet, solid earnings and a positive cashflow. Conversely, weaker companies are often weak in all these areas.
Look out for trends
Just because a company appears to be making a healthy profit today doesn’t mean it will be in a year’s time. The financial report is an important snapshot in time, but to get an idea of the company’s financial direction, it’s very important to look at trends. As well as sales figures and margins, you should look at the wider industry and competitor performance as well. So think about market pressures, legislative change and technological disruption, and their possible impact on the business. And seek external views on the quality of the company’s workforce and management.
Calculating ratios in the financial statement
Once you’ve covered the bare essentials, it’s often extremely useful to get a little more sophisticated in your analysis of a financial report. This will involve looking at a number of ratios, each of which tells you more detail about the company’s performance over the recent past and its likely future direction. Don’t be intimidated – they’re all quite simple, but do provide some extremely valuable insight.
Working Capital Ratio
First, calculate the Working Capital Ratio, which tells you about a company’s liquidity – how easily it can put its hands on cash to settle all its short-term debts. Simply divide the value of its current assets by that of its liabilities. If its assets are double the value of its debts, then you get a 2:1 ratio, which is healthy. A 1:2 ratio should certainly sound some warning bells.
Closely related is the Quick Ratio, often called the “acid test”, which aims to identify how fast a company could settle its debts. It does this by subtracting inventory (whose value can often take a long time to realise) from current assets before dividing them by liabilities. Typically, a 1:1 ratio is pretty much what companies are looking for.
Then there is the Price-Earnings (P/E) Ratio, which enables an assessment of the company’s likely future earnings. Take the company’s present share price and divide it by Earnings Per Share over the previous 12 months (EPS – a measure of the amount of net income earned on each share of the company’s stock). Say the share price is £50.00, and that the EPS over the previous year was £5.00 (although it’s incredibly unlikely that the figures will be this neat!). That gives you a PE ratio of 10.00, meaning that people holding shares are paying £10.00 for every £1.00 of annual earnings.
Then it’s your call – do you have sufficient faith in the company’s future earnings to pay this much, or even more? If you think it’s in the right market at the right time with the right technology and right people, then maybe you should take a punt!
Debt Equity Ratio
Next comes the Debt-Equity ratio, which aims to highlight when a company is borrowing too much. Divide total outstanding debt (both long and short-term) by the total amount of capital held by shareholders. The smaller the figure that results, the healthier the company’s position. To properly analyse its value, however, you must compare that figure with other companies in the same market.
And finally, look at the Return-on-Equity ratio to find out how good the company is at generating profits. Take net earnings after tax and take off preferred dividends. Then divide that amount by the value of common equity held in the company. The higher the figure you end up with, the more profitable the company.