Ratio Analysis (Part I)
Ratio Analysis: Introduction
Fundamental Analysis has a very broad scope. One aspect looks at the general (qualitative) factors of a company. The other side considers tangible and measurable factors (quantitative). This means crunching and analyzing numbers from the financial statements. If used in conjunction with other methods, quantitative analysis can produce excellent results.
Ratio analysis isn’t just comparing different numbers from the balance sheet, income statement, and cash flow statement. It’s comparing the number against previous years, other companies, the industry, or even the economy in general. Ratios look at the relationships between individual values and relate them to how a company has performed in the past, and might perform in the future.
For example current assets alone don’t tell us a whole lot, but when we divide them by current liabilites we are able to determine whether the company has enough money to cover short term debts.
Before we delve into the different ratios and how they work, let’s briefly discuss where you can find the data for each ratio.
To do ratio analysis the first step is to find the data. For the 19 ratios we will be taking you through we are using a fictitious company, Cory’s Tequila Co. All the data for these examples will be provided, but when you decide to do this on your own there are several different areas that you can find the latest financial figures for a particular company. Finding financial reports is easier than ever thanks to the Internet, here are some sources:
Analyzing the Financial Statements
There is a lot to be said for valuing a company, it is no easy task. If you have yet to discover this goldmine, the satisfaction one gets from tearing apart a companies financial statements and analyzing it on a whole different level is great – especially if you make or save yourself money for your efforts.
In this section we will try to present 19 basic fundamental analysis ratios to help you get started. The ratios are presented in a simplified manner to make them easier to understand. Sure some of the ratios have different varieties, but by the end you will understand the basic premise and reasons for fundamental analysis.
1. Average Interest Rate = (Interest Expense – Accounts Payable) / Liabilities
Indicates the average interest rate that a company borrows at.
Things to remember
* This is a rough estimate, the ratio does not account for everything.
* Using the before tax or after tax interest expense will produce different results.
Interest Rate Analysis:
There are several versions of this ratio, some people prefer to just use interest bearing liabilities such as the bonds and other short term loans. This formula won’t give you the exact interest rate they are paying, but it is useful in an interest rate sensitive environment. And if you compare it to previous years then you are able to tell what rate the company had to take on more debt at. If you will notice from the balance sheet above, Cory’s Tequila Co. doesn’t have any long term debt – therefore you will not find an interest expense. What a great position to be in, practically debt free.
2. Book Value Per Share – BV = (Stockholders Equity – Preferred Stock) / Average Outstanding Shares
Somewhat similar to the earnings per share, but it relates the stockholder’s equity to the number of shares outstanding, giving the shares a raw value.
Things to remember
* Comparing the market value to the book value can indicate whether or not the stock in overvalued or undervalued.
* During bull markets the stock price is more likely to trade significantly higher than book value, and in a bear market the two value’s may be close to equal.
Book Value Analysis:
For the most part the book value really doesn’t tell us a whole lot. Cory’s Tequila Co. is trading at over $100 and the BV is only $3.57? What is up with that? Well BV is considered to be the accounting value of each share, drastically different than what the market is valuing the stock at. And the truth is that market and book value have nothing in common. Market value is what the investment community’s expectations are and book value is based on costs and retained earnings. One situation where BV can be useful is if the market value is trading below the book value, this rarely happens, but if it does it could mean that the company is undervalued and might be an attractive buy.
3. Cash Flow to Assets = Cash from Operations / Total Assets
This ratio indicates the cash a company can generate in relation to its size.
Things to remember
* Comparing to previous years is important, if the company’s ratio is decreasing then they may eventually run into cash problems.
Cash Flow to Assets Analysis:
Cash flow is often overlooked when people analyze a company. You can be a profitable company but if you don’t have cash moving around to pay bills then you are really in trouble. It relates a company’s ability to generate cash compared to its asset size. A ratio of 0.30 is quite good, Cory’s Tequila Co. shouldn’t run into any problems generating cash. When the ratio declines below 10% then there may be some cause for concern.