Four Key Questions when using Financial Information and Interpreting Accounting Ratios

There are many traps in using financial information and interpreting accounting ratios.

You are advised to approach the job with caution and always keep in mind four key questions:

1. Am I comparing like with like?
2. Is there an explanation?
3. What am I comparing it with?
4. Do I believe the figures?

1.  Am I comparing like with like?

Financial analysts pay great attention to the notes in accounts and to the stated accounting policies.

One of the reasons for this is that changes in accounting policies can affect the figures and hence the comparisons.

For example:

• Consider a company that writes off research and development costs as overheads as soon as they are incurred.
• Then suppose that it changes policy and decides to capitalize the research and development, holding it in the Balance Sheet as having a long-term value.
• A case can be made for either treatment but the change makes it difficult to compare ratios for different years.

2.  Is there an explanation?

Do not forget that there may be a special reason for an odd-looking ratio.

For example:

• Greetings card manufacturers commonly deliver Christmas cards  in August with an arrangement that payment is due on 1 January.
• The 30 June Balance Sheet may show that customers are taking an average of 55 days' credit.
• The 31 December Balance Sheet may show that customers are taking an average of 120 days' credit.
• This does not mean that the position has deteriorated dreadfully and the company is in trouble
• The change in the period of credit is an accepted feature of the trade and happens every year.
• It is of course important, particularly as extra working capital has to be found at the end of each year.

3.  What am I comparing it with?

A ratio by itself has only limited value.

It needs to be compared with something.

Useful comparisons may be with the company budget, last year's ratio, or competitors' ratios.

4.  Do I believe the figures?

You may be working with audited and published figures.

On the other hand, you may only have unchecked data rushed from the accountant's desk.

This sort of information may be more valuable because it is up to date.

But beware of errors.

Even if you are not a financial expert, if it feels wrong, perhaps it is wrong.

Accounting Ratios - these are among the most important

There are many useful ratios that can be taken from accounts.

The following are among the most important but there are many others.

• Profit turnover
• Return on Capital Employed 
• Stock turn
• Number of Days' Credit Granted
• Number of Days' Credit Taken
• Dividend per Share
• Price/earnings ratio

When going through a set of accounts, it is a good idea to pick out relevant figures, work out the ratios and try to draw conclusions.

For all the ratios, if you have access to frequently produced management accounts, the ratios will be more useful.




Questions to ask yourself regarding Accounting Ratios:

1. What was the ratio of Profit to Turnover?
2. What was the Return on Capital Employed?
3. What was the Stock Turn?
4. What was the number of days' credit granted?  (Ignore possible GST or VAT implications)
5. What is the working capital?  Does this give cause for concern?

Keep an eye on the accounting ratios

These are always useful, but are particularly so if a business is in trouble.

You should know what is acceptable and you should monitor trends over a period.

If things are going wrong, this may spotlight the dangers and indicate where remedial action is needed.

Gearing and the number of days' credit given and taken may be especially useful.

Value Investing - Important Financial Ratios

Important Ratios

The following is a simple discussion for the most important ratios a value investor should consider: 1. PE ratio, 2. PEG ratio, 3. Net profit margin , 4. Return on assets (ROA) , 5. Return on Equity (ROE), 6. Debt/Equity Ratio , 7. Current Ratio.

1). PE Ratio (P/E) 

Price/earnings ratio is the most common measure of how expensive a stock is. The P/E ratio is equal to a stock's market capitalization divided by its after-tax earnings over a 12-month period, usually the trailing period but occasionally the current or forward period.

In ordinary periods, most stocks trade between a 10-25 P/E ratio. Stocks with higher forecast earnings growth will usually have a higher P/E, and those expected to have lower earnings growth will in most cases have a lower P/E. Peter Lynch thinks the P/E ratio of any company that's fairly priced will equal to its growth rate.

The bottom line on Price/earnings ratio for the best value stock is: PE Ratio < 20

2). PE Ratio To Growth Ratio (PEG)

The PEG ratio is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company's expected growth. PEG is equal to P/E ratio divided by EPS growth ratio .

In general, the P/E ratio is higher for a company with a higher growth rate. Thus using just the P/E ratio would make high-growth companies overvalued relative to others. It is assumed that by dividing the P/E ratio by the earnings growth rate, the resulting ratio is better for comparing companies with different growth rates.

The PEG ratio is considered to be a convenient approximation. It was popularized by Peter Lynch. He thinks a fairly valued company will have its PEG equal to 1. So a lower ratio is "better" (cheaper) and a higher ratio is "worse" (expensive).

The bottom line on PEG ratio for the best value stock is: PEG < 1.

3). Net Profit Margin 

Net profit margin is a key method of measuring profitability which is calculated as net income divided by revenues, or net profits divided by sales . It can be interpreted as the amount of money the company gets to keep for every dollar of revenue. A 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales.

When a company has a high profit margin, it usually means that it also has one or more advantages over its competition. Companies with high net profit margins have better control over its costs compared to its competitors and have a bigger cushion to protect themselves during the hard times. Companies with low profit margins can get wiped out in a downturn.

The bottom line on net profit margin for the best value stock is: Net profit margin > 10%.

4). Return on Assets (ROA) 

ROA gives an idea as to how efficient management is at using its assets to generate earnings. An indicator of how profitable a company is relative to its total assets.

ROA for public companies can vary substantially and will be highly dependent on the industry. This is why when using ROA as a comparative measure, it is best to compare it against a company's previous ROA numbers or the ROA of a similar company.

For example, if one company has a net income of $1 million and total assets of $5 million, its ROA is 20%; however, if another company earns the same amount but has total assets of $10 million, it has an ROA of 10%. Based on this example, the first company is better at converting its investment into profit.

Management's most important job is to make wise choices in allocating its resources. Anybody can make a profit by throwing a ton of money at a problem, but very few managers excel at making large profits with little investment.

The bottom line on return on assets for the best value stock is: Return on assets > 10%.

5). Return on Equity (ROE) 

ROE is viewed as one of the most important financial ratios. It measures a firm's efficiency at generating profits from every dollar of net assets (assets minus liabilities), and shows how well a company uses investment dollars to generate earnings growth. ROE is equal to a fiscal year's net income divided by total equity .

Buffett always looks at ROE to see whether or not a company has consistently performed well in comparison to other companies in the same industry. Looking at the ROE in just the last year isn't enough. The investor should view the ROE from the past five to 10 years to get a good idea of historical performance.

The bottom line on Return on Equity for the best value stock is: Return on Equity > 15%.

6). Debt to Equity Ratio

The debt/equity ratio is a key characteristic Buffett considers carefully. Buffett prefers to see a small amount of debt so that earnings growth is being generated from shareholders' equity as opposed to borrowed money.

The debt/equity ratio is a measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.

If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing.

The bottom line on debt/equity ratio for the best value stock is: Debt/Equity Ratio < 1.

7). Current Ratio 

The ratio is mainly used to give an idea of the company's ability to pay back its short-term liabilities with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its obligations.

A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point. While this shows the company is not in good financial health, it does not necessarily mean that it will go bankrupt - as there are many ways to access financing - but it is definitely not a good sign.

The current ratio can give a sense of the efficiency of a company's operating cycle or its ability to turn its product into cash. Companies that have trouble getting paid on their receivables or have long inventory turnover can run into liquidity problems because they are unable to alleviate their obligations. Because business operations differ in each industry, it is always more useful to compare companies within the same industry.

The bottom line on current ratio for the best value stock is: Current Ratio > 1

http://www.trade4rich.com/Ratio.html

Financial Ratio Tutorial

Financial Ratio Tutorial
By Richard Loth (Contact | Biography)

When it comes to investing, analyzing financial statement information (also known as quantitative analysis), is one of, if not the most important element in the fundamental analysis process. At the same time, the massive amount of numbers in a company's financial statements can be bewildering and intimidating to many investors. However, through financial ratio analysis, you will be able to work with these numbers in an organized fashion.

The objective of this tutorial is to provide you with a guide to sources of financial statement data, to highlight and define the most relevant ratios, to show you how to compute them and to explain their meaning as investment evaluators.

In this regard, we draw your attention to the complete set of financials for Zimmer Holdings, Inc. (ZMH), a publicly listed company on the NYSE that designs, manufactures and markets orthopedic and related surgical products, and fracture-management devices worldwide. We've provided these statements in order to be able to make specific reference to the account captions and numbers in Zimmer's financials in order to illustrate how to compute all the ratios.

Among the dozens of financial ratios available, we've chosen 30 measurements that are the most relevant to the investing process and organized them into six main categories as per the following list:

1) Liquidity Measurement Ratios

• - Current Ratio
• - Quick Ratio
• - Cash Ratio
• - Cash Conversion Cycle

2) Profitability Indicator Ratios

• - Profit Margin Analysis
• - Effective Tax Rate
• - Return On Assets
• - Return On Equity
• - Return On Capital Employed

3) Debt Ratios

• - Overview Of Debt
• - Debt Ratio
• - Debt-Equity Ratio
• - Capitalization Ratio
• - Interest Coverage Ratio
• - Cash Flow To Debt Ratio

4) Operating Performance Ratios

• - Fixed-Asset Turnover
• - Sales/Revenue Per Employee
• - Operating Cycle

5) Cash Flow Indicator Ratios

• - Operating Cash Flow/Sales Ratio
• - Free Cash Flow/Operating Cash Ratio
• - Cash Flow Coverage Ratio
• - Dividend Payout Ratio

6) Investment Valuation Ratios

• - Per Share Data
• - Price/Book Value Ratio
• - Price/Cash Flow Ratio
• - Price/Earnings Ratio
• - Price/Earnings To Growth Ratio
• - Price/Sales Ratio
• - Dividend Yield
• - Enterprise Value Multiple

Read more: http://www.investopedia.com/university/ratios/#ixzz1iiTyzb3S


Also read:

7 Courses Finance Students Should Take

http://myinvestingnotes.blogspot.com/2011/12/7-courses-finance-students-should-take.html

Sharemarket basics: a numbers game

Money Magazine, April 2007

Investing in shares can be something of a numbers game, especially when the financial press is peppered with mention of ratios such as "dividend yield" and "earnings per share". There is no shortage of these statistics and they can be useful as a means of assessing whether a particular share offers good returns or strong growth prospects.

On this basis, ratios are worth adding to your armoury of research, though they are by no means infallible. To begin with, ratios use historical data, which is not necessarily a guide for what will happen in the future. And the source data can be open to accounting manipulation, so any insights that ratios provide should be viewed with caution.

Let's take a look at some of the key share market ratios (though this list is by no means exhaustive).

Dividend yield: Calculated by dividing the most recent dividend by the current share price and multiplying by 100 to achieve a percentage figure. Dividend yield is a measure of the regular income return (rather than capital growth) that a share is paying, which allows a comparison between different shares, and also against other asset classes. However, when the share price changes the dividend yield will also change. Indeed, if the share price crashed, the yield would soar, until the next dividend is declared — if there is one.

Earnings per share (EPS): calculated by dividing the net profit of a company by the total number of shares issued. By looking at a company's EPS history, it is possible to see the growth in earnings from one year to the next; and you can compare earnings to the dividend payouts and the share price each year.

Price earnings (PE) ratio: Calculated by dividing the share price by the earnings per share. This often-quoted ratio is a way of measuring investors' expectations about a company's performance, and it is often used to describe whether an individual company, or even the share market as a whole, is "expensive", in the sense that it is overpriced.

Overall share market conditions will have a bearing on the relative PE ratios of different shares but, as a guide, a company with a PE ratio of about 16 is considered to be a growth-orientated company, meaning there's a good chance its earnings will rise. By contrast, a company with a PE ratio of less than 11 may be regarded as having less rosy prospects for earnings growth.

While the PE ratio can be useful for making comparisons between companies, this ratio generally makes more sense if the companies under review operate within the same industry (as average PEs vary between industries), and face the same overall market conditions.

Dividend cover: Calculated as EPS divided by dividend per share. This ratio shows the proportion by which a company's dividend is covered by its earnings. A figure of less than 1.0, for example, suggests the company is paying out more than it is earning. Investors should look for a figure above 1.0, which suggests the company can comfortably pay its dividends.

Net Tangible Assets (NTA): Calculated as the value of shareholders' funds (as reported in the company's balance sheet) divided by the number of issued shares. Also known as the "asset backing", this ratio can give investors an indication of what each share in a company would be worth if all the assets were liquidated and all debts were paid and the remaining proceeds were distributed to ordinary shareholders on a per share basis.

Investors sometimes use the NTA to assess the desirability of a share. If the NTA is greater than the share price, it may be that the company is undervalued — potentially making it a takeover target. Conversely, if the NTA is below the share price, the market may be overvaluing the company.

For the complete story see Money Magazine's April 2007 issue.

http://money.ninemsn.com.au/article.aspx?id=260404

Financial Ratios for Management, Owners and Lenders

Financial Ratios and Their Uses

KEY TAKEAWAYS

Earnings per share (EPS) and dividends per share (DPS) indicate stock returns on investment.

Dividend yield measures a shareholder’s cash return relative to investment.

Growth ratios such as the internal and sustainable growth rates indicate the company’s ability to grow given earnings and dividend expectations.

Market value ratios, most commonly price to earnings and price to book, indicate a stock’s market popularity and its effects on its price.


http://www.web-books.com/eLibrary/NC/B0/B65/73MB65.html

Comparative Industry and Company Financial Ratios

Just looking at a single ratio does not really tell you much about a company.  You also need a standard of comparison, a benchmark.   There are three principal benchmarks used in ratio analysis.

Financial ratios can be compared to the:

1. ratios of the company in prior years, 
2. ratios of another company, and
3. industry average ratios.

1.  Historical comparison.

The first useful benchmark is history.

• How has the ratio changed over time?
• Are things getting better or worse for the company?
• Is gross margin going down, indicating that costs are rising faster than prices can be increased?
• Are receivable days lengthening, indicating there are payment problems?

2.  Competitor comparison.

The second useful ratio benchmark is comparing a specific company ratio with that of a competitor.

• For example, if a company has a significantly higher return on assets than a competitor, it strongly suggests that the company manages its resources better.

3.  Industry comparison.

The third type of benchmark is an industry-wide comparison.

• Industry-wide average ratios are published and can give an analyst a good starting point in assessing a particular company's financial performance.  Click here for a chart showing various ratios for a variety of companies in different industries:

  Comparative Industry and Company Financial Ratios

Note that there can be large differences in ratio values between industries and companies.

Review the chart.  What do the ratios tell us about companies and industries?