Financial analysts make an effort to see the secret behind the numbers of financial statements. Is the firm healthy, is it performing better or worse this year compared to previous years or the competition. Comparing financial statements among competitors faces several problems. On the one hand the difference in size of companies (eg Ford /Toyota) makes it cumbersome to compare numbers. The first approach to standardizing financial statements is to express them as a percentage. Balance sheet positions will be listed as a percentage of total assets, income statement positions are going to be listed as a percentage of total sales, cash flow positions will be listed as a percentage of total sources of cash or total uses of cash.
A further step in comparing financial statements is to choose a base year and reflect changes to it in percentage points. Nevertheless, this does not yet address the problem of financial statements denominated in different currencies.
Fiancial ratios are generally simple in concept: take two numbers from financial statements, divide them and give the result a name. This has lead to a huge number of ratios (pick your ratio) which I categorize as follows:
1) Liquidity measures (ability of a company to pay its bills)
2) Asset management measures (how efficiently does this company use its asset to obtain sales)
3) Profitability measures (how efficiently does the firm manage its operations)
4) Market Value measures (does the stock price reflect the real value of the company).
Liquidity measures
The best known ratios could be the current ratio (current assets/current liabilities) and also the "Quick (or Acid-Test) Ratio" ((current assets - Inventory)/Current liabilities). The higher the ratio the easier a company will be able to meet its current bills.
The Acid Test takes into consideration that inventory might be difficult to sell, hence the exclusion of inventory from the ratio.
The total debt ratio ((Total Assets - Total Equity)/Total Assets) is concerned with the long term viability of a business. Being concerned about bankruptcy one hopes for a low total debt ratio. However,
debt might be used to utilize the company's assets better and generate higher profits.
Asset Management measures
Inventory Turnover and Days Sales in Inventory is calculated as inventory turnover = (Cost of Goods Sold)/ Inventory. The resulting quotient then is needed as follows: (365 days/Inventory turnover)= Days' sales in inventory. This number will indicate how many days on average inventory sits before it is sold.
Similarly, you can calculate how long it takes a company to collect on its receivables (so-called: Receivalbes Turnover). In the first step you divide: Sales /Accounts Receivable which gives you the Receivables turnover. In a second step you figure out the Days' sales in receivables: 365 days/Accounts Receivables.
Profitability Measures
The most famous profitability measure is the profit margin which divides Net Income/Sales showing how much profit a company makes for every dollar sold. As much as everyone likes a high profit margin, some companies are more successful lowering their price tags and selling more at a lower margin (think Walmart).
Return on Assets (ROA=Net Income/Total Assets) reveals how well our assets contributed to your profits. ROE (Return on Equity=Net Income/Total Equity) explains how much cash was generated through the shareholders' investment.
Market Value Measures
Price-Earnings Ratio means : price per share/earnings per share. The PE ratio is widely used to show that the dot com era overvalued shares. At the height of the Dot-com bubble P/E had risen to 32. The collapse in earnings caused P/E to go up to 46. 50 in the following year: 2001. Historically the PE ratio has been around 15 %.
A PE between 0-10 might indicated that the company stock is undervalued, 17 and above might show that
company stock is overvalued.
Accountants together with financial analysts have addressed their original question: how to compare different companies. Then again, even though we are able to compare financial data now more advanced than before, the real topic: -is the copmany over or undervalued? - remains unanswered. Ratios that make sense for one industry,
seem extravagant in another kind of business (eg compare the financial sector and manufacturing). Geographic location also influences the ratios without anyone knowing why. Maybe the thought that mathematics may not determine the value of a company is comforting. Naturally, we would not want to exchange Warren Buffett’s genius for a spreadsheet.
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