Key Accounting Ratios and Measures for the Capital Markets

Chapter 6: Key Accounting Ratios and Measures for the Capital Markets

• The analysis of financial statements is primarily conducted through the use of ratios.

• Importance of Ratios: Ratio calculations provide limited insights on their own. Valuable interpretations emerge when these ratios are compared against historical data, industry peers, or averages.

Profitability, Performance, and Growth

Return on Equity (ROE)

• Definition:

  • $ROE = rac{ ext{Profit After Tax}}{ ext{Shareholders' Equity}}$

• Significance:

  • ROE indicates the amount of return generated for shareholders in relation to their equity investment.

  • Year-on-year comparisons help evaluate if a company wisely utilizes equity finance to foster growth.

  • By comparing ROE across companies in the same industry, investors can gauge if a company provides better returns than its competitors.

  • Investors may use this metric to assess if it meets their personal investment thresholds considering the associated risks.

Dupont Decomposition of ROE

• The formula can be broken down into:

  • $ROE = ext{Net Profit Margin} imes ext{Asset Turnover} imes ext{Asset to Equity Ratio}$

1. Net Profit Margin:

   • $ext{Net Profit Margin} = rac{ ext{Profit After Tax}}{ ext{Sales}}$

   • It shows profit retained for every $1 of sales post all expenses (including taxes and interest). A higher percentage suggests better cost control related to sales pricing.

2. Asset Turnover:

   • $ext{Asset Turnover} = rac{ ext{Sales}}{ ext{Total Assets}}$

   • This metric measures effective use of assets in generating sales; a higher number signifies better asset utilization.

3. Asset to Equity Ratio:

   • $ext{Asset to Equity} = rac{ ext{Total Assets}}{ ext{Shareholders' Equity}}$

   • Helps assess the financing mix used for operations between debt and equity. A higher number indicates heavier reliance on debt.

Efficiency in Resource Utilization

• Asset Management: Focus on management's effectiveness in using available resources rather than profit alone.

1. Net Working Capital to Sales:

   • $ext{Net Working Capital to Sales} = rac{ ext{Net Working Capital}}{ ext{Revenue}}$

   • Indicates investment needed in working capital per $ of revenue. Lower values imply efficient use of short-term resources.

2. Net Working Capital Turnover:

   • $ext{Net Working Capital Turnover} = rac{ ext{Revenue}}{ ext{Net Working Capital}}$

   • Reveals revenue generated for every dollar invested in working capital. Higher numbers point to better short-term resource usage.

3. Days Receivable:

   • $ext{Days Receivable} = rac{ ext{Accounts Receivable}}{ ext{Revenue}} imes 365$

   • Measures the average time taken to collect on sales; shorter durations indicate efficient cash realization.

4. Days Payable:

   • $ext{Days Payable} = rac{ ext{Accounts Payable}}{ ext{Cost of Sales}} imes 365$

   • Reflects the average time taken by the company to pay supplies; longer durations may indicate effective working capital management as cash is retained longer.

5. Inventory Days:

   • $ext{Inventory Days} = rac{ ext{Inventory}}{ ext{Cost of Sales}} imes 365$

   • Indicates the days taken to sell inventory; lower numbers suggest more efficient inventory turnover.

Liquidity Ratios

• Purpose: Liquidity ratios assess an organization’s capability to meet current obligations with available resources. Higher ratios suggest better financial stability.

1. Current Ratio:

   • $ext{Current Ratio} = rac{ ext{Current Assets}}{ ext{Current Liabilities}}$

   • A value over 1 indicates the company can meet short-term obligations through current assets.

2. Quick Ratio:

   • $ext{Quick Ratio} = rac{ ext{Current Assets} - ext{Inventory}}{ ext{Current Liabilities}}$

   • A stricter measure than the current ratio, assessing immediate financial health without relying on inventory liquidation.

   • Values over 1 denote a financially stable organization.

3. Cash Ratio:

   • $ext{Cash Ratio} = rac{ ext{Cash and Cash Equivalents}}{ ext{Current Liabilities}}$

   • Evaluates the capability to meet current obligations utilizing only cash reserves. Value of 1 indicates strong financial stability.

Long-Term Solvency

• Understanding long-term survival necessitates evaluating the firm’s long-term financing sources and its ability to meet resulting obligations.

1. Debt to Equity Ratio:

   • $ext{Debt to Equity Ratio} = rac{ ext{Total Debt}}{ ext{Shareholders' Equity}}$

2. Debt to Capital Ratio:

   • $ext{Debt to Capital Ratio} = rac{ ext{Total Debt}}{ ext{Total Debt} + ext{Shareholders' Equity}}$

   • Both ratios provide insight into reliance on debt compared to equity; higher values indicate increased risk of failing to meet obligations.

Interest Cover Ratios

• Interest Cover (Earnings Method):

  • $ext{Interest Cover} = rac{ ext{Operating Profit}}{ ext{Finance Expense}}$

• Interest Cover (Cash Flow Method):

  • $ext{Interest Cover} = rac{ ext{Cash Flow from Operations (before interest)}}{ ext{Interest Paid}}$

• As these ratios approach 1, the risk of defaulting on financial obligations increases.

Ratio Analysis in Practice

• Analysts can utilize ratio analysis in three main ways:

  1. Time-Series Comparison: Compare ratios over several years to assess a company’s strategy effectiveness over time.

  2. Cross-Sectional Comparison: Evaluate a company's performance relative to others in the industry while keeping industry-level factors constant.

  3. Absolute Benchmark Comparison: Compare ratios against defined standards over an industry or economic context.

Properties of Good Ratios

• Ratios should be:

  • Well-defined to yield meaningful conclusions from financial analysis.

  • Able to measure historical operating performance and evaluate firm strategy and management decisions.

  • Ideally, Linked through an economic rationale between numerator and denominator in a linear fashion.

  • Consistent in measuring and comparing units between numerator and denominator.

Consistency of Measurement Units: Stock vs Flow

• Stock Items: Values at a specific point in time, like balance sheet items (e.g., fixed assets).

• Flow Items: Measured over time (e.g., revenue, expenses), creating potential for inaccuracies in ratio measurement when combining stocks with flows.

Standardizing Financial Ratios

• To draw valid inferences from financial ratios, standardize data presentation for comparative analysis among different firms and accounting practices.

Capital Market Metrics

• Adjustments and assessments should consider:

  • One-off transactions or balances to avoid misinterpretation of ratio shifts.

  • The inclusion of non-GAAP metrics as companies adapt reporting processes to reflect operational realities better.

Non-GAAP Metrics Examples

• Companies may report adjusted figures to communicate performance distinctively:

  • Walmart - ROI and ROA

  • Amazon - Free cash flows

  • CVS Health - Adjusted Operating Income

  • United Health Group - Adjusted EPS (quarterly only)

  • Exxon Mobil - Adjusted earnings figures

  • Berkshire Hathaway - Gain in float

  • Alphabet - Constant currency revenue figures and growth metrics.