The Power of Financial Ratios

Ratios indicate the relationship of one number to another. People use them every day. A football player’s scoring rate per matches played, that is, how many goals scored for a given number of games. The odds of winning a lottery jackpot, say one in 6 million, show the relationship between winning tickets sold (1) and total tickets sold (6 million). Ratios don’t require any complex calculations. To figure a ratio, usually, you just divide one number by another and then express the result as a decimal or as a percentage.

All kinds of people use all kinds of financial ratios in assessing a business. For example:

·       Bankers and other lenders examine ratios such as debt-to-equity, which gives them an idea of whether a company will be able to pay back a loan.

·       Senior managers watch ratios such as gross margin, which helps them be aware of rising costs or inappropriate discounting.

·       Credit managers assess potential customers’ financial health by inspecting the quick ratio, which gives them an indication of the customer’s supply of ready cash compared with its current liabilities.

·       Potential and current shareholders look at ratios such as price-to-earnings, which help them decide whether a company is valued high or low by comparison with other stock (and with its own value in previous years).

The ability to calculate them – to read between the lines of the financials, so to speak – is a mark of financial intelligence. Learning about ratios will give you a host of intelligent questions to ask your boss or CFO. And, of course, I’ll show you how to use them to boost your company’s performance.

The power of ratios lies in the fact that the numbers in the financial statements by themselves don’t reveal the whole story. Is net profit of $10 million a healthy bottom line for a company? Who Knows? It depends on the size of the company, on what net profit was last year, on how much net profit was expected to be this year, and on many other variables. If you ask whether a $10 million profit is good or bad, the only possible answer is the one given by the woman in the old joke. Asked how her husband was, she replied, “Compared to what?”

Ratios offer points of comparison and thus tell you more than the raw numbers alone. Profit, for example, can be compared with sales, or with total assets, or with the amount of equity shareholders have invested in the company. A different ratio expresses each relationship, and each gives you a way of gauging whether a $10 million profit is good news or bad news. As we’ll see, many of the different line items on the financials are incorporated into ratios. Those ratios help you understand whether the numbers you’re looking at are favourable or unfavourable.

What’s more, the ratios themselves can be compared. For instance:

·       You can compare ratios with themselves over time. Is profit relative to sales up or down this year? This level of analysis can reveal some powerful trend lines – and some big warning flags if the ratios are headed in the wrong direction.

·       You can also compare ratios with what was projected. To pick just one of the ratios we’ll be examining in this part, if your inventory turnover is worse than you expected it to be, you need to find out why.

·       You can compare ratios with industry averages. If you find that your company’s key ratios are worse than those of your competitors, you definitely want to figure out the reason. To be sure, not all the ratio results we discuss will be similar from one company to another, even in the same industry. For most, there’s a reasonable range. It’s when the ratios get outside of that range, as Sunbeam’s DSO did, that its worth your attention.

There are four categories of ratios that managers and other stakeholders in a business typically use to analyse the company’s performance: profitability, leverage, liquidity, and efficiency. I will give you examples in each category. Note, however, that many of these formulas can be tinkered with by the financial folks to address specific approaches or concerns. Tinkering of this sort doesn’t mean that anyone is cooking the books, only that they are using their expertise to obtain the most useful information for particular situations (yes, there is art even in formulas). What I will provide are the foundational formulas, the ones you need to learn first. Each provides a different view – like looking into a house through windows on all sides.

First, do no harm

 To employees

To stakeholders

 

To the community

 

To the government and institutions and laws and rules

 

To the environment…

 

Thereafter, the sky is the limit

Risk Analysis

Risk Assessment Process and Analysis

There is, of course, no return without risk. There is a tendency in investment project modelling to believe that the cash flows from investment models are somehow “real”. The inputs for the model may or may not occur, and, at best, are a considered estimate of what might happen two or more years into a project time span.

Since finance theory teaches that rational people are risk averse, then the next stage of the exercise should be to include in the model techniques for estimating the risk and uncertainty. The model should be tested to see how likely the organisation is to achieve the desired net present value. The upsides may not be a problem, but management needs to assess the possibility of lower than anticipated returns. Again, following theory, if the project earns a lower rate than the cost of capital, then the shareholder value in the company diminishes.

Two types of risk can be identified:

·       Project risk. Which is the variability of the project return.

·   Corporate risk. Since management need to invest in a mixture of projects, which have varying degrees of risk and potential return.

Risk could also be split into two categories:

·       Risk. Which can be described and quantified using some of the techniques in this lesson.

·       Uncertainty. Which can be described as random events.

Sources of risk and uncertainty could include one or more of the following:

·       Commercial and administration.

·       Competitive responses leading to reduced demand.

·       Market shifts, especially with new technology.

·       Financial – liquidity, profitability, and financial structures.

·       Knowledge and information dissemination.

·       Legal issues.

·       Currency issues, both on the supply and sales sides.

·       Partners, suppliers and subcontractors.

·       Political events in home and overseas markets (for instance, Brexit, President Trump impeachment, and so on).

·       Health emergencies (for instance, Covid-19, Ebola, HIV/AIDS).

·       Economic cycles and the effect on demand and prices.

·       Quality issues leading to reduced sales.

·       Resource availability leading to lower production.

·       Technical ability of company.

·       Innovation, copyright and the availability of new technologies.

·       Management competence and drive.

Project risk is related to corporate risk since the latter will change if management invests in risky projects.

Financial Planning and Investments

Many of the financial decisions that individuals have to make in their personal lives - choosing a mortgage, investing in their savings, planning for retirement - require using financial models. In this blog I illustrate additional applications of the time value of money concept and also involve inflation and taxation.

Inflation

Inflation is one of the key factors that has to be incorporated in many models for making personal finance decisions, especially when long-term planning is involved. If you are saving money to buy a car three years from now, inflation may not be an important factor. But if you are 30 now, plan to retire at age 65, and expect to live until you are 90, inflation must be factored into the models you use. For example, it is impossible for any of us to guess how much we will need in nominal Rands per year during retirement - it may be 35 years away! However, we may be able to say more comfortably that we will need in today’s Rands (also called constant Rands or buying power) an amount equal to 80% of our current expenses.

Long-term planning has to be done in one of two ways. We can do the analysis in constant or real Rands, but then we cannot reflect taxes realistically because taxes have to be paid on nominal rand income and investment returns, not on real rand amounts. Alternately, we can do all calculations in nominal Rands but carefully reflect in them the impact of anticipated inflation.

Taxes

We generally have to factor in three types of taxes into our models: income taxes, taxes on dividends (if any), and taxes on capital gains.

Income taxes apply to wages, salaries, and other income, as well as most interest income (except where there may be exemptions, for example on savings or certain bonds). This tax is charged at different rates depending on one’s income level or tax bracket. Unless you want to calculate income taxes in detail by taking into consideration different rates for different tax brackets, you should generally use the marginal tax rate in your models.

Capital gains are defined as the appreciation in the value of an investment asset. One important point to keep in mind is that capital gains taxes have to be paid only when the asset is sold (unless there are applicable exemptions, for example on your primary home); until then no taxes have to be paid, even if the asset’s value keeps growing. When we buy and sell assets over time in tranches, the calculation of the capital gains taxes can get somewhat complicated.

In building models, you have to know whether you are dealing with taxable accounts, tax-deferred accounts, or tax-free accounts. Sometimes you can develop models that will work for both taxable and tax-deferred or even tax-free accounts. For taxable applications, the user has to input the appropriate tax rate, and for tax-deferred and tax-free applications the user will set the tax rates to zero. However, not all models can be built with this flexibility, and you should always document any tax-related limitation a model.

Reinvestment Income

Many stocks pay dividends, and most fixed income investments (for example, bonds) provide ongoing interest income. Unless these investments are in tax-deferred accounts, we have to pay taxes on these returns before reinvesting the funds at rates available at that time. Because the taxes and the reinvestment rates we assume can significantly affect actual returns earned over time, our models should explicitly incorporate them and let the user specify the tax rates as well as reinvestment rates.

Structuring Portfolios

For long-term investment success, it is essential that an investor creates and maintains a properly structured portfolio. A portfolio is generally structured at three levels.

First, the investor has to choose the broad asset classes (for example, stocks, bonds, etc.) in which to invest and decide how much of the portfolio to invest in each asset class. That is generally called the portfolio’s asset allocation. Studies have shown that a portfolio’s asset allocation has the largest impact on its long-term return.

Second, the investor has to choose within each asset class the categories of securities in which to invest. For stocks, the categories may be large-cap stocks, small-cap value stocks, and so on. For bonds, these may be short-term bonds, long-term bonds, foreign bonds, and so on. The investor must then decide what percentage of his allocation to each asset class he wants to allocate to each category within that class.

Third, within each category of securities the investor has to choose specific securities and mutual funds and decide how much to invest in each of them. To make this decision, the investor will probably start with a select list of stocks of funds in each category and then do an allocation among them.

Although both financial theory and analysis of historical data provide some guideline for portfolio structuring, there is quite a bit of leeway in choosing the allocation at each level. There is no perfect answer, and even for the same person the “right” portfolio will change over the years as family circumstances change (for example, children finish college, the person approaches retirement, and so forth). Although most people think they should adjust their portfolios at least periodically in response to changing market outlook, market history shows that no one can reliably predict what the market will do in the future and which stocks will do better than others over the years. Contrary to what most people believe, then, the structure and holdings of a portfolio should not be influenced much by anyone’s views on the market outlook.

A Step-By-Step Guide to Analysing Capital Expenditures

You’ve been talking with your boss about buying a new piece of equipment for the plant, or maybe mounting a new marketing campaign. He ends the meeting abruptly. “Sounds good”, he says. “Write me up a proposal with the ROI and have it on my desk by Monday”.

Don’t panic, here’s a step-by-step guide to preparing your proposal.

A.     Remember that ROI means “return on investment” – just another way of saying, “Prepare an analysis of this capital expenditure”. The boss wants to know whether the investment is worth it, and he wants calculations to back it up.

B.     Collect all the data you can about the cost of the investment. In the case of a new machine, total costs would include the purchase price, shipping costs, installation, factory downtime (while installation occurs), debugging, and so on. Where you must make estimates, note that fact. Treat the total as your initial cash outlay. You will also need to determine the machine’s useful life, not an easy task (but part of the art I enjoy so much!) You might talk to the manufacturer and to others who have purchased the equipment to help you answer the question.

C.     Determine the benefits of the new investment, in terms of what it will save the company or what it will help the company to earn. A calculation for a new machine should include any cost savings from greater output speed, less rework, a reduction in the number of people required to operate the equipment, increased sales because customers are happier, and so on. The tricky part here is that you need to figure out how all these factors translate into an estimate of cash flow. Don’t be afraid to ask for help from your finance department – they are trained in this kind of thing and should be willing to help.

D.    Find out the company’s hurdle rate (remember, this is the interest rate you will use to discount the future cash flows) for this kind of investment. Calculate the net present value of the project using this hurdle rate.

E.     Calculate payback and internal rate of return as well. You’ll probably get questions about what they are from your boss, so you need to have the answers ready.

F.     Write up the proposal. Keep it brief. Describe the project, outline the costs and benefits (both financial and otherwise), and describe the risks. Discuss how it fits with the company’s strategy or competitive situation. Then give your recommendations. Include your NPV, payback, and IRR calculation in case there are questions about how you arrived at your results.

Managers sometimes go overboard in writing up capital expenditure proposals. It’s probably human nature: we all like new things, and it’s usually pretty easy to make the numbers turn out so that the investment looks good. But I advise conservatism and caution. Explain exactly where you think the estimates are good and where you think they may be shaky. Do a sensitivity analysis, and show (if you can) that the estimate makes sense even if cash flows don’t materialise at quite the level you hope. A conservative proposal is one that is likely to be funded – and one that is likely to add the most to the company’s value in the long run.

Reading an Income Statement

Before you even start contemplating the numbers, you need some context for understanding the document.

The Label

Does it say “income statement” at the top? It may not. It may instead say “profit and loss statement” or “P&L statement”, “operating statement” or “statement of operations”, “statement of earnings” or “earnings statement”. Often the word consolidated is in front of these phrases. With all these terms for the same thing, one might get the idea that our friends in finance and accounting don’t want us to know what is going on. Or, maybe they just take it for granted that everybody knows that all the different terms mean the same thing. However, that may be, in this course I will always use the term income statement.

Incidentally, if you see “balance sheet” or “statement of cash flows” at the top, you have the wrong document. The label pretty much has to include one of the above phrase I just mentioned.

What It’s Measuring

Is this income statement for an entire company? Is it for a division or a business unit? Is it for a region? Larger companies typically produce income statements for various parts of the business as well as for the whole organisation. H. Thomas Johnson and Robert Kaplan, in their classic book Relevance Lost, tell how General Motors developed the divisional system – with income statements for each division – in the first half of the twentieth century. We can be glad it did. Creating income statements for smaller business units has provided managers in large corporations with enormous insights into their financial performance.

Once you have identified the relevant entity, you need to check the time period. An income statement, like a report card in school, is always for a span of time: a month, quarter, or year, or maybe year-to-date. Some companies produce income statements for a time span as short as a week. Incidentally, the figures on large companies’ income statements are usually rounded off, and the last zeros are left off. So, look for a little note at the top: “in millions” (add six zeros to the numbers) or “in thousands” (add three zeros). This may sound like common sense, and indeed it is. But I have found that seemingly trivial details such as this are often overlooked by financial newcomers.

“Actual” versus “Pro-Forma”

Most income statements are “actual”, and if there’s no other label, you can assume that is what you’re looking at. They show what “actually” happened to revenues, costs, and profits during that time period according to the rules of accounting. (I put “actually” in quotes to remind you that any income statement has those built-in estimates, assumptions, and biases, which I will discuss in more detail later in this part of the course).

Then there are what’s known as pro forma income statements. Sometimes pro forma means that the income statement is a projection. If you are drawing up a plan for a new business, for instance, you might write down a projected income statement for the first year or two – in other words, what you hope and expect will happen in terms of sales and costs. That projection is called a pro forma. But pro forma can also mean an income statement that excludes any unusual or one-time charges. Say a company has to take a big write-off in a particular year, resulting in a loss on the bottom line. (More on write-offs later in this part). Along with its actual income statement, it might prepare one that shows what would have happened without the write-off.

Be careful of this kind of pro forma! Its ostensible purpose is to let you compare last year (where there was no write-off) with this year (if there hadn’t been that ugly write-off). But there is often a subliminal message, something along the lines of, “Hey, things aren’t really as bad as they look – we just lost money because of that write-off”. Of course, the write-off really did happen, and the company really did lose money. Most of the time, you want to look at the actuals as well as the pro-formas, and if you have to choose just one, the actuals are probably the better bet. Cynics sometimes describe pro-formas as income statements with all the bad stuff taken out, which is how it sometimes appears.

The Big Numbers

No matter whose income statement you’re looking at, there will be three main categories. One is sales, which may be called revenue (it’s the same thing). Sales or revenue is always at the top. When people refer to “top-line growth”, that’s what they mean: sales growth. Costs and expenses are in the middle, and profit is at the bottom. (If the income statement you’re looking at is for a non-profit, “profit” may be called “surplus/deficit” or “net revenue”). There are subsets of profit that may be listed as you go along, too – gross profit, for example. I’ll explain all of these in a later lesson.

You can usually tell what’s important to a company by looking at the biggest numbers relative to sales. For example, the sales line is usually followed by “cost of goods sold”, or COGS. In a service business the line is often “cost of services”, or COS. If that line is a large fraction of sales, you can bet that management in that company watches COGS or COS very closely. In your own company, you will want to know exactly what is included in line items that are relevant to your job. If you’re a sales manager, for instance, you’ll need to find out exactly what goes into the line labelled “selling expense”. As we’ll see, accountants have some discretion as to how they categorise various expenses.

By the way: unless you’re a financial professional, you can usually ignore items like “consolidated, liquidating securitisation entities”. Most line with labels like that aren’t material to the bottom line anyway. And if they are, they ought to be explained in the notes.

Reading a Balance Sheet

First, however, find a sample balance sheet, either your own company’s or one in an annual report (or just look at the sample below). Since the balance sheet shows the company’s financial situation at a given point in time, there should be a specific date at the top. It’s usually the end of a month, quarter, year, or fiscal year. When you’re looking at financial statements together, you typically want to see an income statement for a month, quarter, or year, along with the balance sheet for the end of the period reported. Unlike income statements, balance sheets are almost always for an entire organisation. Sometimes a large corporation creates subsidiary balance sheets for its operating divisions, but it rarely does so for a single facility. As we’ll see, accounting professionals have to do some estimating on the balance sheet, just the way they do with the income statement. Remember the delivery business? The way we depreciate the truck affects not only the income statement but also the value of assets shown on the balance sheet. It turns out that the assumptions and biases in the income statement flow into the balance sheet one way or another.

Balance sheets come in two typical formats. The traditional model shows assets on the left-hand side of the page and liabilities and owners’ equity on the right side, with liabilities at the top. The less traditional format puts assets on top, liabilities in the middle, and owners’ equity on the bottom. Whatever the format, the “balance” remains the same: assets must equal liabilities plus owners’ equity. (In the non-profit world, owners’ equity is sometimes called “net assets”). Often a balance sheet shows comparative figures for, say, 31 December of the most recent year and 31 December of the previous year. Check the column headings to see what points in time are being compared.

As with income statements, some organisations have unusual line items on their balance sheets that you may not find discussed in this course. Remember, many of these items may be clarified in the footnotes. In fact, balance sheets are notorious for their footnotes. Ford Motor Company’s 2004 annual report contained a whopping thirty pages of notes, many of them pertaining to the balance sheet. Indeed, companies often include a standard disclaimer in the notes making the very point about the art of finance that I am making in this course. Ford, for instance, says:

Use of Estimate

The financial statements are prepared in conformity with generally accepted accounting principles in the United States. Management is required to make estimates and assumptions that affect reported amounts and disclosures. Actual results could differ from those assumptions. Estimates and assumptions are periodically reviewed, and the effects of any material revisions are reflected in the financial statements in the period that they are determined to be necessary.