Financial Ratio Analysis

 There are many types of financial ratio analysis but those that will typically be used include: 

· Liquidity

· Leverage

· Activity

· Profitability

· Growth

Income Statement Tips:

· All line items expressed as a % of revenue should divide by net revenue, not gross

· Break out all operating expenses as much as possible

· Break out interest expense and interest income

· Look at past trends in expenses as a % of revenue

· Find out components of COGS. Is a certain raw material expense about to increase a lot? Do they have a sourcing contract about to roll-off? 

Balance Sheet Tips:

· For any ratio based on book value (shareholders’ equity), strip out goodwill. Use tangible book = shareholders’ equity – goodwill.

· For debt ratios, including capitalized leases

· Create a debt table. Is debt about to mature? Will the new rate be higher or lower? Check the maturity schedule. 

“Liquidity ratios” gauge a company’s ability to meet short-term obligations. Credit analysts at banks use these ratios to monitor their corporate clients, and fixed income managers use them when analyzing companies.

“Current Ratio” =  Current Assets

                             Current Liabilities

The higher this ratio, the more liquid assets a company has to cover its short-term liabilities.

“Quick Ratio” = Current Assets – Inventory

                                 Current Liabilities

This is a stricter gauge because inventory cannot be “quickly” liquidated to pay bills. A credit analyst would look at this in the context of inventory turns, also known as the “acid test” ratio.

“Leverage ratios” gauge a company’s risk in the context of its debt levels. Is it generating sufficient EBITDA (D&A is a non-cash expense) to meet its interest payments? 

Debt Multiple =   Avg. of Beg/End Year Total Debt

                                               EBITDA

Interest Coverage =  EBITDA + Other Income

                                                Interest

Cost of Debt =  Interest Expense

                 Avg. of Beg/End Year Total Debt

Note: When calculating any ratio where the numerator is an income statement item and the denominator is a balance sheet item or vice versa, always use an average for the balance sheet item. Income is over some time; the balance sheet is a snapshot in time. 

Activity ratios gauge a company’s efficient utilization of its assets.

Inventory Turnover =  COGS

                              Avg. Inventory

Asset Turnover =   Revenue

                              Avg. Assets

Days in Receivables = Avg. Accounts Receivable x 360

                                                    Revenues

Days in Payables = Avg. Accounts Payable x 360

                                                  COGS

Example: 

How many times a year does a company turn over its inventory if:

Dec. 31, 2012 inventory = $100

Dec. 31, 2013 inventory = $120

COGS in 2013 income statement = $220

Inventory turnover = $220/(($100 + $120)/2) = 2x

In 2013, they sold twice the inventory they carried on average. So, they sold the entire beginning of year amount, manufactured a second batch, and sold that too. 

“Profitability Ratios” gauge a company’s performance relative to its competitors, and to its historical results.

Gross Margin =  Gross Profit

                               Revenue

EBIT (operating) Margin =   EBIT

                                            Revenue

EBITDA Margin =  EBITDA

                               Revenue

Net Margin =  Net Income

                          Revenue

Remember gross profit = revenue – COGS. EBIT = operating income. EBITDA = EBIT + D&A (from cash flow statement)

Annual growth, such as revenue or EPS growth, year over year is expressed in models as Y/Y.

If this year’s revenue = $100, last year’s = $90, the “year over year” growth rate was 

$100/$90 - 1 = 11.1%

Sequential growth refers to a company’s quarterly results’ growth versus the prior quarter, 90 days prior. 

If 3Q was $20, and 2Q was $19, the “sequential growth” was $20/$19 – 1 = 5.3%

Sequential growth rates are expressed in models as Q-Q and are looked at to gauge if growth is rising or slowing within a year. Quarterly results are also looked at on Y/Y basis, not just Q-Q.