There are many types of financial ratio analysis but those that will typically be used include:
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
The higher this ratio, the more liquid assets a company has to cover its short-term liabilities.
“Quick Ratio” = Current Assets – Inventory
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
Interest Coverage = EBITDA + Other Income
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
Asset Turnover = Revenue
Days in Receivables = Avg. Accounts Receivable x 360
Days in Payables = Avg. Accounts Payable x 360
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
EBIT (operating) Margin = EBIT
EBITDA Margin = EBITDA
Net Margin = Net Income
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.
Compounded Annual Growth Rate (CAGR, pronounced “kay-ger”) shows the average annual growth rate over some time longer than a year. For counting the number of years, let’s say it’s from 2005-2013, the number of years is 8, not 9. There are 9 years represented, but 8 years elapsed. For instance, from 2005 to 2006, 1 year elapsed, not 2 years.
2005 revenue = $10 2013 revenue = $30
2013 minus 2005 = 8 years
CAGR = $30/$10, to the power of (1/8) minus 1 CAGR is 15%