Analyze Investments Quickly With Ratios

Jonas Elmerraji

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Ratios can be an invaluable tool for making an investment decision.  Using ratios to make informed decisions about an investment makes a lot of sense, once you know how use them.

There are a large variety of ratios out there, but financial ratios can be broken up into four major categories:

1. profitability ratios,
2. liquidity ratios, 
3. solvency ratios and 
4. valuation ratios. 

 (To continue learning the basics to analyzing a company, see our Ratio Analysis, Introduction To Fundamental Analysis and Advanced Financial Statement Analysis tutorials.) 

Profitability Ratios

- Profitability is a key piece of information that should be analyzed when you're considering investing in a company. 

- This is because high revenues alone don't necessarily translate into dividends for investors (or increased stock prices, for that matter) unless a company is able to clear all of its expenses and costs.

-  Profitability ratios are used to give us an idea of how likely it is that a company will turn a profit, as well as how that profit relates to other important information about the company.

One example of an important profitability ratio is the profit margin.

The profit margin is calculated as follows:

In general, the higher a company's profit margin the better but, as with most ratios, it is not enough to look at it in isolation. It is important to compare it to the company's past levels, to the market average and to its competitors.

There are a couple of red flags you should watch out for with the profit margin, especially where the company is seeing decreasing profit margins year over year. This can suggest changing market conditions or where the company is seeing increasing competition or rising costs. Also, if a company's profit margin is out of line compared to the rest of its industry, it is worth the extra effort to find out why.

-  If a company has a really low profit margin, it could mean the company will land in a bad position if market conditions change. 

-  A really high profit margin relative to an industry could mean that the company has arrangements or advantages that might not last.

Other profitability ratios include operating margin and gross margin. (Read more about margins in Zooming in on Net Operating Income, The Bottom Line On Margins and Measuring Company Efficiency.)

Liquidity Ratios

-  Liquidity is a measure of how quickly a company's assets can be converted to cash. 

-  Liquidity ratios can give investors an idea of how capable a company will be at raising cash to purchase additional assets or to repay creditors quickly, either in an emergency situation, or in the course of normal business.

The receivables turnover ratio is a liquidity ratio that measures a company's ability to collect on debts and accounts owed to them.

Receivables turnover is calculated as follows:

-  This ratio represents the number of times in the period that the payments owed to a company will be collected. 

-  If you divide 365 by the receivables turnover ratio, you will find the average number of days that it takes a company to collect on receivables, or the number of days between the time it takes a company to make a credit sale and the time that it receives a cash payment..

-  In the case of this ratio, a higher number means that the company collects more frequently (good liquidity), whereas a low ratio may mean that clients are not paying up in a timely manner. Like most ratios, the true value of the information isn't really there unless you make a comparison across the industry.

Other liquidity ratios include working capital turnover, inventory turnover and current ratio. (To continue reading on liquidity, see Do Your Investments Have Short-Term Health?, Working Capital Works and Inventory Valuation For Investors: FIFO And LIFO.)

Solvency Ratios

-  Solvency ratios are used by investors to get a picture of how well a company can deal with its long-term financial obligations and develop future assets. 

-  As you might expect, a company weighed down with debt is probably a less favorable investment than one with a minimal amount of debt on its books.

The total debt to total assets ratio is used to determine how many of a company's assets were paid for with debt.

Total debt to total assets is calculated as follows:

When using this ratio to make an analysis of a company, it can be really helpful to look at the company's as well as making industry comparisons. It's not unrealistic for a younger company to have a debt to total assets ratio closer to "1" (more assets were financed by debt), as it hasn't yet had a chance to eliminate its debt.

As a general rule, a number close to zero is generally better, because it means that more assets were paid for without debt. Remember, lenders have first claim on a company's assets if they're forced to liquidate. But again, it will depend on the industry, as those with highly capital intensive operations will have a higher relative debt level.

Other solvency ratios include times interest earned and free cash flow (FCF). (To read on, see Debt Reckoning, Free Cash Flow: Free, But Not Always Easy and Taking Stock Of Discounted Cash Flow.)

Valuation Ratios

-  Valuation ratios are used to analyze the attractiveness of an investment in a company. 

-  The idea is that by using these ratios investors can gain an understanding of how cheap or expensive a company company's current stock price is compared to several different measures. 

-  In general, the less expensive a company is, the more attractive an investment in that company becomes.

The price to earnings (P/E) ratio is the most well-known valuation ratio that compares the company's stock price to the amount of earnings it generates on a per-share basis. An easy way to think about the P/E ratio is that it's a pretty good indicator of investors' expectations of a company's future income. That is, it's the premium that the market is willing to pay for a particular security's earnings.

The P/E ratio is calculated as follows:

-  The ratio can be compared to past levels for the company along with industry competitors and the overall market. 

-  It transforms any company's earnings into an easily comparable measure. 

-  Basically, it will tell you how much an investor are willing to pay for $1 of earnings in that company - the higher the ration, the more they are willing to spend. 

-  But don't think that a higher P/E ratio for one company necessarily suggests that its stock is overpriced. 

-  Different industries have substantially different P/E ratios, so the P/E really shouldn't be used for inter-industry comparisons. 

(To continue reading about the P/E, see Understanding The P/E Ratio, Move Over P/E, Make Way For The PEG and Are lower P/E ratio stocks always better investments?)

Other valuation ratios include price-to-book, price-to-sales and price-to-cash flow. (To see more, read Operating Cash Flow: Better Than Net Income?,Use Price-To-Sales Ratios To Value Stocks, Value By The Book and What's the difference between book and market value?)

What You Need to Know

-  Ratios are comparison points for companies. 

-  They can be used to evaluate one stock in an industry versus another in the same field. Likewise, they can be used to measure a company today against its historical numbers. 

-  It's essential to remember, though, that when using ratios to make analyses, the comparisons need to make sense. 

-  Expecting the same P/E or profitability ratio out of a textile company that you do out of a software company isn't going to help you make any valuable inferences about either company in its respective market.

Think of each industry as having a map-like scale - you wouldn't take a ruler to a globe and to a map of your hometown and expect an inch to represent the same distance on both. Keep your scales (and industries) straight and the numbers can reveal a lot.

Conclusion

-  The information you need to calculate ratios is easy to come by: Every single number or figure you need can be found in a company's financial statements (which can be found online on the company's website or on most stock quote sites). 

-  Once you have the raw data, you can plug in right into your financial analysis and put those numbers to work for you. (To learn more, see Get Organized With An Investment Analysis Form.)

Everyone wants an edge in investing but one of the best tools out there frequently is frequently misunderstood and avoided by new investors. When you understand what ratios tell you, as well as where to find all the information you need to compute them, there's no reason why you shouldn't be able to make the numbers work in your favor.

by Jonas Elmerraji

Jonas Elmerraji is the editor of the Rhino Stock Report, a new GARP investment newsletter now in free BETA.

In addition to writing for Investopedia.com, Elmerraji is a contributor to numerous business and investment publications, including TheStreet.com and Entrepreneur.

Read more: http://www.investopedia.com/articles/stocks/06/ratios.asp#ixzz1hbE8zH8W

Padded Pensions Add to New York Fiscal Woes

May 20, 2010
Padded Pensions Add to New York Fiscal Woes
By MARY WILLIAMS WALSH and AMY SCHOENFELD

In Yonkers, more than 100 retired police officers and firefighters are collecting pensions greater than their pay when they were working. One of the youngest, Hugo Tassone, retired at 44 with a base pay of about $74,000 a year. His pension is now $101,333 a year.

It’s what the system promised, said Mr. Tassone, now 47, adding that he did nothing wrong by adding lots of overtime to his base pay shortly before retiring. “I don’t understand how the working guy that held up their end of the bargain became the problem,” he said.

Despite a pension investigation by the New York attorney general, an audit concluding that some police officers in the city broke overtime rules to increase their payouts and the mayor’s statements that future pensions should be based on regular pay, not overtime, these practices persist in Yonkers.

The city has even arranged for its police to put in overtime as flagmen on Consolidated Edison construction sites. Though a company is paying the bill, the city is actually reporting the work as city overtime to the New York State pension fund, padding future payouts — an arrangement at odds with the spirit of public employment, if not the law.

The Yonkers experience shows how errors, misunderstandings and wishful thinking are piling hidden new costs onto New York’s public pension system every year, worsening the state’s current fiscal crisis. And the problem is not just in New York. Public pension costs are ballooning everywhere, throwing budgets out of whack and raising the question of whether venerable state pension systems are viable.

In fact, the cost of public pensions has been systemically underestimated nationwide for more than two decades, say some analysts. By these estimates, state and local officials have promised $5 trillion worth of benefits while thinking they were committing taxpayers to roughly half that amount.

The use of public money for outsize retirement pay really stings when budgets don’t balance, teachers are being laid off, furloughs are being planned and everything from poison-control centers to Alzheimer’s day care is being cut, as is happening in New York.

According to pension data collected by The New York Times from the city and state, about 3,700 retired public workers in New York are now getting pensions of more than $100,000 a year, exempt from state and local taxes. The data belie official reports that the average state pension is a modest $18,000, or $38,000 for retired police officers and firefighters. (The average is low, in part, because it includes people who worked in government only part time, or just a few years, as well as surviving spouses getting partial benefits.)

Roughly one of every 250 retired public workers in New York is collecting a six-figure pension, and that group is expected to grow rapidly in coming years, based on the number of highly paid people in the pipeline.

Payouts for Decades

Some will receive the big pensions for decades. Thirteen New York City police officers recently retired at age 40 with pensions above $100,000 a year; nine did so in their 30s. The plan’s public information officer said that the very young retirees had qualified for special disability pensions, which are 50 percent larger than ordinary police pensions. He said several dozen of the highest-paid New York City police retirees had disabilities related to 9/11 and the rest of the disabilities resulted from injuries in the line of duty.

In virtually every case, the officials who granted the rich pensions thought they were offering something affordable, because the cost estimates were too low.

Before Yonkers adopted a richer pension formula for police in 2000, for instance, it was told the maximum cost would be $1.3 million a year. But instead, the yearly cost is now $3.75 million and rising.

David Simpson, a spokesman for the mayor of Yonkers, said pension cost projections were “often lowballs,” so the city could get stuck. “Once you give something, you can’t take it away,” he said.

Police pensions and overtime have been a sore point in Yonkers for many years and were the subject of an exposé in The Journal News in Westchester in 2009. A special audit of police overtime in Yonkers in 2007 found that the police department had failed to enforce its own rules, creating pervasive opportunities for abuse.

Despite all the attention, police are now being paid as flagmen by Con Edison on their days off, Mr. Simpson confirmed, adding that the city was tacking the extra hours onto their pay, which is then reported to the state pension fund.

“The system encourages police to take as much overtime as they can in the last year before retirement. That’s the way the system is structured,” he said. “There’s nothing illegal or unethical about this.”

In fact, a Con Edison spokesman, Robert McGee, said a number of other towns also require the company to use their police officers as flagmen, raising its labor costs.

A spokesman for the New York State comptroller’s office said that the city was in error and pointed to a 1986 decision by the Supreme Court of New York that found that hours worked by police for outside businesses could not be included in their state-paid pensions.

“It has long been established that such overtime from private special duty cannot be included,” said the spokesman, Mark Johnson.

The question of how to pay for generous benefits is proving a challenge to New York and many other states whose revenue has fallen and whose debts have become harder to manage, while public officials try to limit the kind of deep service cuts that often mean political death. Some hard-pressed governments are belatedly coming to the grim conclusion that they have promised workers more than their sagging economies can deliver.

Outside the United States, Greece and Spain have recently reduced government pensions to deal with burdensome debt that has impeded their ability to finance themselves. The new British coalition government has said it will review public pension costs there as well.

Municipalities in this country cannot easily follow suit even as financial problems mount, though, because reducing benefits for their existing employees is considered impossible under the current laws of most states.

The New York State constitution bars public employers from slowing the rate at which workers build up their pensions over the course of their careers. That degree of protection contrasts sharply with the private sector, where companies can generally change the rate at which workers build their benefits at any time. Furthermore, as companies have reduced pensions substantially over the last two decades, states and cities have embellished theirs with sweeteners like inflation adjustments and lower retirement ages that appealed to unions and their members, who vote.

Police and other safety workers are in many cases allowed to retire with full pensions after 20 years. Other workers can often do so after 30 years, even as young as 55, although future hires in New York will have to work to age 62 to get their full benefits, under a law passed in January.

Census data from 2008 show that the typical state or municipal pension is substantially richer than the typical company pension — $15,941 versus $7,904 — for retirees aged 65 and older. By tradition, public employees have said they accepted lower salaries in exchange for better benefits, but the Census data show this has not been true for a number of years. In 2008 the median pay for a worker in the private sector was $39,877, compared with $45,124 for a state or local employee. The data show broad national aggregates that do not try to compare similar occupations.

And, while companies must adhere to uniform federal guidelines about setting aside money to pay pensions, states do not. Some, like New Jersey, have failed to fund their pensions for years and have fallen so far behind they may never catch up again. New York City and New York State have been more diligent about contributing the required amounts each year — but the required amounts now turn out to have been too low, in part because they counted on solid investment returns that have not materialized.

In Yonkers, contributions to the state pension fund keep rising. This year, to save money, the city is proposing to eliminate about 90 police jobs, out of 640. The savings, though, will not even cover the extra cost of the overtime-enriched pensions. Meanwhile, the police say the layoffs will make the situation worse, because shrinking the police force means those who remain must work even more overtime, driving up pension costs even more.

An online, searchable database compiled by The Times contains the names and pensions of about 3,700 public retirees in New York who receive more than $100,000 a year. Information was provided by New York State’s two big pension plans, one for teachers and the other for other state and local workers outside New York City.

Four of New York City’s five big pension funds also provided data. But the city police pension fund listed the six-figure amounts being collected by 536 retired police officers without giving their names. The pension plan for the city’s firefighters has yet to provide the information, as required by public information law.

Even without names, the pension list from the New York City police plan shows a trend toward very youthful retirement, at a time when the city’s contributions to the police pension fund have risen sharply.

New York City has budgeted a contribution of about $2 billion for this year — about 64 percent of the police payroll, one of the highest pension contribution rates in the United States. That amount does not yet include money to make up for the investment losses of 2008, so the rate is almost sure to rise.

A Variety of Occupations

Not all the people getting six-figure pensions are former police and firefighters from cities with liberal overtime and disability policies. Hundreds more worked at hospitals, power utilities, port authorities and other “public benefit corporations” — hybrid entities that compete with the private sector and pay their officials accordingly, but allow them, at the same time, to participate in the state pension fund.

Edward A. Stolzenberg makes a good example. He started out more than three decades ago in the Westchester County government; today, in retirement, he collects $222,143 a year, one of the biggest pensions paid by the New York State pension fund.

In between, he became county health commissioner, running the Westchester Medical Center when it was a big, struggling county hospital. The county made it a public benefit corporation in 1997, with a mandate to grow and compete with the big hospitals in New York City.

In the process Mr. Stolzenberg’s salary shot up. By the time he retired, he was the highest-paid official in Westchester County, he said, with a salary of more than $400,000 a year. That was still less than the rate at a for-profit hospital, he said.

“In a time when the state budget is pretty bad and money is pouring out, people look at pensions and say, ‘This is terrible! Why are people getting this kind of money?’ ” he acknowledged. “It may not be viable. But that’s the way the state structured it.”

He added that his successor at the medical center was making more than $900,000 and accruing a pension.

Companies that find they have overpromised have a way out. They can declare bankruptcy, and if a judge approves, they can send their pension plans to the federal agency that insures corporate pensions. That agency limits its coverage to what is considered a basic pension, currently $54,000 for a 65-year-old retiree, much less for younger people. If Yonkers could send its police plan to the federal guarantor, for instance, Mr. Tassone, at 47, would have his benefit cut from $101,333 to just $15,660.

But state plans don’t have such an insurance program, much less any definition of a basic, guaranteed benefit.

Federal tax law does put a cap on pension payouts, currently $195,000 a year. Congress set this cap, which has risen with inflation, more than 30 years ago to keep employers from turning their pension funds into abusive tax shelters.

But New York State found a way around it. In 1997, lawmakers created a safe-harbor mechanism allowing retirees to collect bigger pensions legally — a second pool of money called the Excess Benefit Fund. Towns all over the state pay the associated costs, even though only a few of them have retirees who qualify. At least 28 recipients in New York get pensions above $195,000 a year. One of the highest is George M. Philip, who gets $261,037 after retiring as chief executive and chief investment officer of the New York State teachers’ pension fund. Since retiring, he has gone back to work as president of the State University of New York at Albany, drawing an additional $280,000 last year.

New York’s attorney general, Andrew M. Cuomo, has said public pensions are getting out of hand, and has begun an investigation of places, like Yonkers, where there are unusual concentrations of six-figure retirees.

But he may well find that most recipients have done nothing illegal. The benefits have been enacted by legislators, signed into law by governors, hailed by comptrollers and adopted by local officials — all of whom were told by actuaries and other financial advisers that the pensions would cost just a fraction of what they are now turning out to cost.

“In very few cases do they know what they’re agreeing to,” said Edmund J. McMahon, director of the Empire Center for New York State Policy, which tracks pension costs. “They almost always obscure the costs, from themselves and from the public.”

Offended by Comments

Mr. Cuomo did not name Mr. Tassone but spoke of a Yonkers officer who had retired at 44 on $101,033 a year. Mr. Tassone said all his neighbors knew it was him, and he bristles at the implication that he got more than he was supposed to. He said he could correctly document all the overtime he worked, and that the practice was approved by the mayor and city council.

The special audit in Yonkers named Mr. Tassone in its sample of retirees with unusual overtime records, but did not accuse him of doing anything wrong. Disciplinary proceedings were brought against only one officer, who is now retired.

Mr. Tassone said the only reason he joined the police force was the promise of a full pension after just 20 years, and it would have been wrong for the state or city to go back on the promise after using it to recruit him.

He said he put up with hardships for 20 years as a police officer, “and now I’m at the end of it and I’ve become a target,” he said. “I broke my hand three times. I broke my left ankle. I blew out my knee. In my last two years alone, I made between 350 and 400 arrests, and a lot of those people weren’t volunteering.”

Because he could retire young, he added, it was important to start out with the largest pension possible. In the coming years, inflation will eat away at his benefit. Public pensions in New York City and State have had a cost-of-living adjustment feature since 2000, but it applies only to the first $18,000.

“I concede, I have a very good pension, but what’s that pension going to be worth when I’m 70 years old?” Mr. Tassone said.

Although limited to the first $18,000, the cost-of-living adjustment was the most expensive pension enhancement enacted in recent memory in New York, according to the Independent Budget Office. The cost has, once again, proved higher than expected.

Yonkers still offers full pensions to police after 20 years, but just in theory. For the moment, the city is too broke to send any new cadets to the police academy, and retirees are not being replaced.

http://www.nytimes.com/2010/05/21/business/economy/21pension.html?src=me&ref=business

Measure short-term solvency and liquidity

Short-term solvency is the ability to meet short term debts from liquid assets.  Liquid assets include money on short-term deposit and trade receivables, but not inventories, which cannot be quickly turned into cash.


LIQUIDITY versus PROFITABILITY

In the short term liquidity is more essential to financial stability than profitability.  Cash generated from operating activities is a major source of liquid funds, as measured by the statement of cash flows.  There may be other priorities for funds from operating activities, therefore it is important to have sufficient liquid assets to meet short-term debts.



CASH FLOW

The cash operating cycle is the length of time between paying out cash for inputs and receiving cash from sales.  It is a useful measure of the time taken to generate cash.  Cash flow forecasts enable businesses to predict and deal with liquidity problems before they arise.  It is one of the most important measures of future solvency.


THE CURRENT RATIO

Current ratio =  Current assets / Current liabilities

This is a standard test of short-term solvency and simply measure if a business can meet its current liabilities from its current assets.  Depending upon the nature of the business, the current ratio should usually be greater than 1, depending upon the speed of inventory turnover.



THE QUICK RATIO (or ACID TEST RATIO)

Quick ratio = (Current assets less inventory) / Current liabilities

This is a more reliable short-term solvency measure because inventory is not easily convertible into cash for many businesses.  This ratio should be close to 1, depending upon the business.


INTERPRETING LOW AND HIGH RATIOS

Don't interpret current and quick ratios too literally.  Different businesses operate in different ways.  Low ratios are not always indicative of insolvency risk and high ratios are not always healthy.

LOW RATIOS.


For example, a high volume retailer, such as a supermarket could have healthy liquidity but very low current and quick ratios.  Supermarkets have relatively low inventories as their goods are mainly perishable and turnover quickly.  They have minimal receivables as customers pay in cash.  In addition, their purchasing power results in long trade payable payment periods.  Therefore overall - relatively low current assets and relatively high current liabilities.

HIGH RATIOS.


A poorly managed business with slow-selling inventories and many outstanding receivables may have high current and quick ratios.

Short-term solvency is the ability to pay short-term debts from liquid assets.


Related posts:

Measuring Business Performance

Measure Profitability

Measure short-term solvency and liquidity

Measure long-term solvency and stability

Calculate investor ratios

Evaluate a business using ratios

Estimate the value of a business