Financial Ratio Analysis - peer comparison

Without peer comparison the financial ratio analysis can not be complete. What I'm showing you here are five companies' ratios side by side. The five companies are Amazon, Ebay, Walmart, Costco, and Overstock. Pay attention to Amazon and Walmart. As I mentioned in previous post, these two firms really show similar profitability and efficiency performance.  I really found this framework helpful to compare competitors. (Note: don't just assume the best company will have the best price action in the future)

Financial Ratio Analysis (Liquidity ratios and leverage ratios)

Liquidity ratios are about how solvent a firm’s assets can be. Naively put: If the firm is trouble, eg. Short of cash, how quickly can they sell their assets and get cash to get by. There are current ratio, quick ratio (main difference here is there is no inventory for quick ratio). Account payable is a good measure too since if you can postpone your payment to others you have more flexibility. I remember when I looked at Palm’s AP turnover I did see the change as the firm started to get stressed. You know, when a firm is in good shape, the suppliers won’t be too eager to collect their money as long as within reasonable time frame. However, when a firm is in stress, everybody want their money back as soon as possible. (same concept as a bank run, I assume) Some of the liquidity ratios are as follows:

Current ratio                             Current assets / current liabilities

Quick ratio                                (Cash + short-term investments + A/R) / current liabilities

Interest coverage ratio              (Net income + tax expense + interest expense) / interest expense

A/P turnover (times)                 Cost of good sold / average accounts payable

Leverage Ratios represent how the management utilizes capital. I always have trouble reading company’s report saying they’re raising equity while there almost no debt on the balance sheet. Small chinese companies tends to do. Don’t invest on them. Trading them can be dangerous too. Of course we all know, debt level needs to be  balanced. Many issues need to be considered: tax shield, interest coverage, etc. Two important leverage ratios are as follows:

Capital structure leverage       Average total assets / average shareholders’ equity

Long-term debt ratio               Long-term liabilities / total assets

Amazon as the example: liquidity ratios---

It’s interesting to see there is a dip for current ratio in 12/31/09 quarter. Can you guess why? Remember when I discussed the efficiency ratios, Amazon had a great quarter on 12/31/09 and its sales turnover is great and inventory turnover as well. That’s why: not much inventory left. You see, this is how the whole financial analysis framework keeps its integrity.

Leverage’s power can be easily seen from ROE vs ROA. We can simply assume ROE=ROA*Capital structure leverage. So, Amazon has 2 times asset to equity then ROE is two times of ROA. That simple.

Alright, now we should have gone over all the key ratios and let’s look at the framework once again as a whole. Again, it’s like an X-ray for a firm. When you evaluate a company you have to look at all perspectives and ratio analysis is the easiest way to dissect information. After you analyze one company you can compare with its peers eventually; then you might be able to say you have a good feeling about your company if data speaks good things about it.

Note: good financial ratios and trends don't warrant higher stock price since the market might have price in  all the future growth. Although, it does may you feel comfortable when investing a stock with sound fundamentals. In addition, if you are patient enough to get in a good stock with enough "margin of safety" it would be better.

People always wondering what is a stock really worth. Great question but a really hard one to answer. Don't just listen to others for price target since different people might have different trading/investing time frame. I do try to valuate company interested me and I encourage you do your own. However, treat it as an art project rather science one. Challenge your assumptions as new information arrives all the time.

On the other hand, ratio analysis is sort of science project as numbers reveal great informations. You still need to incorporate financial statements, news, research reports, etc to understand the ratios better and make reasonable projections. Well, with some basic accounting intuition financial ratio analysis can really help you diagnosis your company's health. This post concludes the introductory series. Hope it makes sense. 

Financial Ratio Analysis (efficiency ratios)

What does efficiency mean? Plain simple: how effective the company has utilized its assets, how fast can the company collect its revenue, how quickly can the company sell its inventory, etc. The following table lists the important ratios which address above basic questions.

Asset turnover                           Sales / average total assets

A/R turnover                             Sales / average accounts receivable

Inventory turnover                    Cost of goods sold / average inventory

Fixed asset turnover                  Sales / average fixed assets

Working capital                    A/R turnover (days) + inventory turnover (days) – A/P turnover (days)

Let’s put these ratios into work for Amazon. 

If you look at the times of the turnover ratio you want larger number which means higher efficiency. On the other hand, if you look at the number by days you want smaller number, the shorter the better. Amazon has great seasonality so you have to compare YOY. Again 2009 is a dramatic year for recovery so the comparison needs to take that into consideration. Look at Amazon’s numbers I can still say it’s performing great. How does that compare with peers? Who are its peers first? There are just too many. Based on Amazon’s retail concept I’d compare it with Walmart since they both are low margin high efficiency firms. And when I do you’ll see how similar they might look alike. (I will post that for another post in the near future)

I’m just trying to give you guys a short intro and hopefully it can make some sense quickly and easy for you to evaluate a company. For more detail you gotta read a book . Jamie Pratt’s book is good. (I probably should let him know I’m advertising for himJ.

Financial Ratio Analysis (Profitability ratios)

First, what are the profitability ratios? ROE, ROA, Gross margin, profit margin, SG&A/sales etc are included here. Most people are familiar with the term return on equity and think it’s the most important ratio. I would say I do prefer ROA (return on asset) since it best captures operations of the firm (not counting financial stocks here). ROE can be viewed simply as ROA multiplied by capital leverage. Therefore if a company can operate well and with a good business model leverage level should not be hard to adjust in order to maximize shareholder’s return. What’s the money that eventually can be allocated to shareholders? The net income, the profit, the bottom line, etc.  Revenue is on top of income statement so it’s called the top line; now you can guess why net income is called bottom line. You see, accounting is really not that hard to understand, is it?:)

How do you calculate these ratios? Well, if you’re not as ‘diligent’ as I am you can just go Morningstar.com to get almost all the ratios you need. Actually I have automated my data collection process so that it will only take me a few minutes to get all the ratios. Of course, the result depends on the accuracy of original data source (yahoo, google). Based on my observations and tests, the data are generally good. There are great benefits for you to calculate these ratios on your own though as the process will familiarize yourself with the company’s statements and get sense of business items involved. Alright, let’s see what is exactly the math for the profitability ratios. 

Hopefully this is where you tell yourself accounting is really just elementary school mathJ. The way to understand the ratios are also intuitive as I see it. For a good company you like to see high return ratios and margins, but want to have small cost/expense ratios. Make sense?

It’s useful to compare across time for one company but it gets complicated when you compare across different companies due to different business operations. For example, companies like Amazon and Walmart are really low margin operators so you shouldn’t compare them with Intel which has rather high margins.  

Now let’s take Amazon as an example to look at ratios listed in the financial ratio analysis framework. The following picture shows the past four years’ profitability ratios.

What do you see there? Gross margin varies just a little bit but you can see significant improvement on profit margin. Since there are not much change on gross margin what is causing the increase of profit margin? As you might know gross margin subtracting operating expense, interest expense, and tax gives you profit margin. Therefore, the expenses I mention here are reduced year by year. SG&A/sales ratios is part of the operating expense and it is trending downward. In summary, considering economic conditions in 2008 and 2009, the company did a great job by increasing profitability. I’ll discuss ROE and ROA later.

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Financial Ratio Analysis - Introduction

Before I analyze other companies’ ER and ratios let me explain more of the framework first. IU folks should recognize the framework as “ROE Analysis” right away as Jamie Pratt introduces it in Kelley. Some people would say it’s just something similar to Dupont analysis which breaks down ROE to other basic ratios. Well, I’ll just call it in general term: financial ratio analysis framework since it’s kinda more than ROE. What I really appreciate about this model is the integrity: it covers all the financial ratios: profitability ratios, liquidity ratios, efficiency ratios, leverage ratios. In addition, it presents the ratios in the clusters of operations, investing and financing. It really acts like an X-ray for a company’s financial performance. Assuming most of the numbers in financial statements are not fraudulent the framework can serve as a wonderful tool to understand a company’s fundamentals. Jamie Pratt’s book has great illustrations. I’ll have it posted in the post.

Here is a look at the framework. 

It may look overwhelming at first but it should get better after we break it down. There are four main groups of ratios: profitability ratios, efficiency ratios, liquidity ratios, and leverage ratios. I’ll elaborate them in following posts.