What purpose do financial ratios serve? Why would anyone look at a ratio when analyzing a company? After all, it’s just a number. Actually, financial ratios do serve a purpose. A big purpose actually. By themselves, they don’t tell us much. But when compared against other companies and the industry as a whole, they are very valuable. But we have to remember not all industries are the same. Capital intensive industries like energy are much different than healthcare. What may be a good ratio in one may not be in another. So what can a ration tell us when performing our fundamental analysis on a company?
First, they can be used to create industry benchmarks and reveal trends (Ingram 2016). Trends compare data over a period of time, versus a single point in time. They can also address strengths and weaknesses of a company based on financial data from the balance sheet, income statement, and statement of cash flows. This information indicates if a company needs to make a strategic change. They also put companies on equal playing fields based on performance and not size (Ingram 2016). This enables us to compare apples to apples. They are also used in business plans presented to lenders and investors for financing. Finally, they make calculating a relative value of a stock price simple.
What is a financial ratio? It is nothing more than a mathematical expression relating one number to another (Lan 2012). Before we get into the four types, he is the ratios for Universal Health Services:
ACTIVITY RATIOS
Activity ratios indicate how well a company utilizes it assets. How effective is the company turning over its assets and liabilities? The four main ones are the inventory turnover ratio, receivables turnover ratio, payables turnover ratio, and asset turnover ratio. All compare an income statement account (numerator) to a balance sheet account (denominator). Income statement accounts represent a period of time where balance sheet accounts represent a specific point in time: the higher the number the better. This means a company is selling inventory faster, receiving payments sooner, or delaying payments owed to creditors. Universal Healthcare Systems has an asset turnover ratio of 0.94. This means each asset is producing close to $1 in revenue, which is average for the industry.
LIQUIDITY RATIOS
Liquidity ratios indicate a company’s ability to meet its short-term obligations. Does it have enough working capital to pay its liabilities? Ratios over 1.0 mean that they do. The two main ratios are the current ratio and acid ratio. Both compare current assets to current liabilities, except the quick ratio does not include inventory. Inventory sometimes remains over longer periods of time (greater than a year). The current ratio is 1.56 and the quick ratio is 1.46, which indicates it can pay its bills with little difficulty. Also, there isn’t much inventory, which is not unusual for a healthcare service company.
SOLVENCY RATIOS
Solvency ratios, on the other hand, indicate a company’s ability to meet its long-term obligations. With these ratios, we analyze its capital structure: the more leverage used, the higher the risk of default. A company uses leverage because it is cheaper and easier to obtain. Also, there are tax advantages. Interest payments are tax deductible where dividends are not. Lower ratios are better. Universal Healthcare Services has a debt/assets ratio of 0.56 and long term debt/assets of 0.44. Its interest coverage ratio of 11.1 indicates it can easily meet it interest payments.
PROFITABILITY RATIOS
In my opinion, profitability ratios are the most important. They display a firm’s ability to earn money and provide a return to investors. Earnings drive cash flows, which ultimately determine the value of a company displayed by its stock price. In addition, the market and most analysts use earnings in determining the price of a stock. The main ratios are gross profit margin, operating margin, net profit margin, return on assets (ROA) and return on equity (ROE). ROA and ROE are self-explanatory: The margins compare earnings after certain expenses have been deducted to sales. Of these, the most important is operating margin. Earning can be manipulated with “below the line” items like a restructure, accounting change, or a write-off. Therefore, we must focus only on those activities that produce income on a continuous basis. These “above the line” items, or the company’s core business, are what keeps the organization operating as a going concern. Otherwise, the business will ultimately fail in the long run. I look for operating margins of at least 10%.
CAN UHS MEET ITS OBLIGATIONS?
In the short-term, the organization can meet its obligations. The current ratio (1.56) and quick ratio (1.46) are average for the industry. This means UHS has $1.56 available to pay every $1 of liability. Anything over 1.00 indicates a company can meet its obligations. These ratios have risen over the past few years, so there is no indication this will be a problem in the near future. UHS should be fine in the long-term as well. The interest coverage of 11.1 means it has $11.10 of operating earnings to pay every dollar of interest owed on debt. Even though the capital structure is shifting towards more debt (LTD/E of 1.318 in 2015 vs 0.9416 in 2013), total assets are growing faster than overall debt (Debt/assets of 44% in 2015 vs 48% in 2013).
FAVORABLE PROFITABILITY RATIOS
UHS IN FIVE YEARS?
Forecasting anything five years into the future is challenging, especially in the world of finance and a heavily regulated industry like healthcare. It is difficult to predict a value-based purchasing system, especially if fee-for-service reimbursements disappear (Mosquera 2014). Who determines value: the free market or a Washington bureaucrat? Another issue is how do companies respond to the economic dynamic of the local market (Mosquera 2014)? Employers are shifting costs to employees by using health savings accounts with higher deductibles. Growing market share is always an issue, especially in a regulated market. Operating costs are expected to increase over the next few years (Mosquera 2014). Lawsuits and R&D costs aren’t going away anytime soon. If companies are going to succeed, they will need to develop alternative revenue streams, like pharmaceutical research, telemedicine, and ambulatory centers (Mosquera 2014).
UHS is in a position to deal with these issues and create new revenue channels. Their margins are significantly higher than its competitors (ETrade 2016). Even though the capital structure is shifting towards debt, it has shown the ability to deal with this added risk with a coverage ratio that has increased 65% and liquidity ratios increasing 16% over the past three years. Also, with strong cash flows, it is in position to take advantage of acquisition opportunities in an industry headed towards consolidation.
References
Ingram, David. The Advantages of Financial Ratios. Retrieved May 9, 2016, from
http://smallbusiness.chron.com/advantages-financial-ratios-3973.html
Lan, Joe. 16 Financial Ratios for Analyzing a Company’s Strengths and Weaknesses.
Retrieved May 9, 2016, from
http://www.healthcarefinancenews.com/news/5-challenges-facing-health-systems
strengths-and-weaknesses.pdf
Mosquera, Mary. 5 Challenges Facing Health Systems. Retrieved May 9, 2016, from
http://www.healthcarefinancenews.com/news/5-challenges-facing-health-systems
ETrade. (2016). Retrieved May 9, 2016, from
https://www.etrade.wallst.com/v1/stocks/fundamentals/fundamentals.asp?symbol=UHS
