EXECUTIVE SUMMARY
Ratio analysis is one of the most common methods of analyzing a company. They are simple to calculate needing only public information from financial statements. The purpose is to use past relationships of financial accounts to predict future results. Perhaps the most important ratios involve operating income. ROE, gross profit margin, operating margin, and net profit margin give information about how the company achieved results in the past. Of these, operating margin is the most important. This ratio demonstrates a company’s ability to generate income from normal business operations. Look for at least a 10% margin. Extraordinary items and other one-time events should be excluded from the analysis. However, ratios are only useful when used in comparisons. A price-to-cash flow of 5.0 doesn’t tell us much. When compared to a competitor that has a ratio of 3.0, it tells us the market values our company’s ability to generate cash flow more than theirs. If compared to our own ratio of 7.0 the prior year, it means the market thought more of our abilities last year than it does this year. Ratios help in identifying trends that can help management make decisions about the future. The most important question to ask is can the company convert earnings into cash flow? The ones that can are the most successful.
BENEFITS AND LIMITATIONS
Ratio analysis is effective when comparing companies within the same industry. Bloomberg and S&P are two common sources for industry averages (Investopedia 2016). However, you must use similar companies. For example, the food and beverage industry is a broad industry. It is not practical comparing a prepared foods company with a distribution company because the distribution company is more capital intensive (Accounting Explained 2016). Ratios can be useful comparing companies of different sizes. It is easy to look at revenue or EPS and pick the larger company. But size does not tell the whole story. In fact, it can hide flaws. Ratio analysis can expose these flaws.
Ratio analysis is also useful for comparing a company with itself. It is important to evaluate a company over a full economic cycle. This aids with identifying trends. For example, let us say company A has an operating margin of 10% in 2013, 12% in 2014, and 5% in 2015. Are there fundamental issues with the company in 2015? Did management manipulate earnings in 2013 and 2014? What caused the margin to drop by half? A closer look at the income statement could reveal the real issues. Or, maybe cash flows are rising but earnings are not. This is not sustainable over the long term. A close look at the income statement can reveal this trend as well.
But there are limitations with ratio analysis. One is they do not account for inflation (Inc 2016). Inflation can severely impact reported numbers on financial statements. Another is they do not account for seasonal factors, such as back-to-school and Christmas for a retailer. Many companies use difference accounting assumptions and estimates. For example, companies using LIFO vs FIFO inventory methods or double declining balance vs straight line depreciation will report lower earnings. Also, multi-national companies operate different divisions in different industries. Their ratios are difficult to use in comparisons. They are also not useful for comparing companies in different industries. For example, a technology company like Apple will look completely different than an energy company like Exxon, which I will show later. Exxon operates in a much more capital intensive and regulated industry. Finally, a company could have some good ratios and some bad ones. Is the company a good investment or not (Accounting Explained 2016)?
FACTORS IMPACTING RATIO ANALYSIS
The biggest factor affecting ratio analysis is the inputs. Ratio analysis is simple math: numerator/denominator. These come from the financial statements. If the inputs are bad, the output will be bad as well. For example, if sales are overstated or expenses are understated, the profitability ratios will be overstated. Another factor is the economic cycle. If the reporting period does not cover a full cycle, things like inflation and seasonality will not be captured correctly. The period the ratio is being calculated must be the same. Quarterly ratios can look much differently from yearly ones. Finally, the estimates and assumptions used can impact the ratio. Depreciation methods, inventory methods, and revenue recognition will all impact profitability ratios.
There are other factors not directly related to the financial statements that impact ratio analysis as well. For example, what are you comparing against: a prior period or another company similar to yours? Industry factors can impact as well. Highly regulated industries like banks will incur additional costs other industries do not. Where are you in the industry life cycle? Are you analyzing a mature company that pays dividends or a growth company that reinvests earnings back into the company? How about the capital structure? A high debt industry like energy will incur more debt. Additional debt creates additional interest expense. These affect leverage and profitability ratios. Finally, lenders look at ratios when reviewing credit applications. Poor ratios often result in higher interest rates or no approval at all.
EMERGING THEORIES IN RATIO ANALYSIS
The 2008 financial crisis has changed financial analysis in several ways. The focus now is on earnings quality. Analysts want to make sure earnings are consistent, predictable, and sustainable. I suggest an operating margin of at least 10%. Single digit margins indicate the inability to produce consistent earnings. A company must be able to turn earnings into cash flow. While this has always been the case, added emphasis is now placed on analyzing cash flows, whether they are paid out in dividends or reinvested in the company. Capital structures are also scrutinized. One of the key factors of the crisis was debt. Since 2008, interest rates have been close to zero. Once they go up, all of the debt accumulated during this time will incur additional interest expenses. Interest coverage ratios are at the top of many analysts lists. Regulation also has a major impact. It is still unknown the full impact of Dodd-Frank. One thing for sure is additional expenses will be incurred putting pressure on profitability ratios. Dividend yields may also be a significant factor. Cash is king in the finance world. Growth potential is great, but if it can’t be converted into cash, what good is it? Finally, high P/E ratios may be a thing of the past. I expect them to come back to historical averages of around 16. Investors will be reluctant paying a premium for potential earnings since they have been burned by things like the dot.com bubble.
REAL WORLD EXAMPLE: APPLE VS EXXON
Apple (technology) and Exxon (Energy) operate in vastly different industries (E*Trade 2016). The following chart demonstrates how they compare to each other as well as their respective industries.
Apple rates quite favorably to the industry, particularly in the profitability ratios. Liquidity is the only concern. It is still a growth company, so a low dividend yield is not particularly alarming. Notice the P/E ratio that is in the lower 11% of the industry. This is actually good, since a higher P/E ratio implies EPS costs more. The stock price looks cheap based on this metric. Exxon, on the other hand gives mixed result. It is relatively profitable compared to the industry, but with a P/E of 28.85, it looks expensive. It is in a good situation if interest rates rise. One area of concern is the low dividend yield. Dividends are one of the major factors in the energy industry. It is a little surprising it is in the lower 35%.
When compared to each other, Apple seems far superior. It is undervalued compared to Exxon and is much more profitable. Take a close look at ROE (5 times greater) and operating margin (10 times greater). Exxon is in the top 87% of the energy industry, but would be lucky to be in the top 90% in the technology industry. This is an excellent example with the difficulties comparing companies in different industries. Based on this chart, who would ever invest in Exxon? On the other hand, dividends are important in the energy sector. Exxon’s dividend payment is $1.02 per share more that Apple’s. From that standpoint, who would invest in Apple? It is important to compare apples to apples when performing ratio analysis.
References
Accounting Explained. Advantages and Limitations of Ratio Analysis. Retrieved May 25, 2016,
http://accountingexplained.com/financial/ratios/advantages-limitations
E*Trade. Exxon Mobil Fundamentals. Retrieved May 25, 2016, from
https://www.etrade.wallst.com/v1/stocks/fundamentals/fundamentals.asp?symbol=XOM
E*Trade. Apple Fundamentals. Retrieved May 25, 2016, from
https://www.etrade.wallst.com/v1/stocks/fundamentals/fundamentals.asp?symbol=AAPL
Inc. Financial Ratios. Retrieved May 25, 2016, from
http://www.inc.com/encyclopedia/financial-ratios.html
Investopedia. Financial Ratios – Uses and Limitations. Retrieved May 25, 2016, from
http://www.investopedia.com/exam-guide/cfa-level-1/financial-ratios/uses-limitations-
ratios.asp
