Ratio analysis isn’t just comparing different numbers from the balance sheet, income statement, and cash flow statement. It’s comparing the number against previous years, other companies, the industry, or even the economy in general. Ratios look at the relationships between individual values and relate them to how a company has performed in the past, and might perform in the future. Financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a company’s financial statements. The level and historical trends of these ratios can be used to make inferences about a company’s financial condition, its operations and attractiveness as an investment. Financial ratios are calculated from one or more pieces of information from a company’s financial statements. For example, the “gross margin” is the gross profit from operations divided by the total sales or revenues of a company, expressed in percentage terms. In isolation, a financial ratio is a useless piece of information. In context, however, a financial ratio can give a financial analyst an excellent picture of a company’s situation and the trends that are developing. A ratio gains utility by comparison to other data and standards. Taking our example, a gross profit margin for a company of 25% is meaningless by itself. If we know that this company’s competitors have profit margins of 10%, we know that it is more profitable than its industry peers which is quite favourable. If we also know that the historical trend is upwards, for example has been increasing steadily for the last few years, this would also be a favourable sign that management is implementing effective business policies and strategies. Financial ratio analysis groups the ratios into categories which tell us about different facets of a company’s finances and operations. An overview of some of the categories of ratios is given below. Leverage Ratios which show the extent that debt is used in a company’s capital structure. Liquidity Ratios which give a picture of a company’s short term financial situation or solvency. Operational Ratios which use turnover measures to show how efficient a company is in its operations and use of assets. Profitability Ratios which use margin analysis and show the return on sales and capital employed. Solvency Ratios which give a picture of a company’s ability to generate cashflow and pay it financial obligations. It is imperative to note the importance of the proper context for ratio analysis. Like computer programming, financial ratio is governed by the GIGO law of “Garbage In…Garbage Out!” A cross industry comparison of the leverage of stable utility companies and cyclical mining companies would be worse than useless. Examining a cyclical company’s profitability ratios over less than a full commodity or business cycle would fail to give an accurate long-term measure of profitability. Using historical data independent of fundamental changes in a company’s situation or prospects would predict very little about future trends. For example, the historical ratios of a company that has undergone a merger or had a substantive change in its technology or market position would tell very little about the prospects for this company. Credit analysts, those interpreting the financial ratios from the prospects of a lender, focus on the “downside” risk since they gain none of the upside from an improvement in operations. They pay great attention to liquidity and leverage ratios to ascertain a company’s financial risk. Equity analysts look more to the operational and profitability ratios, to determine the future profits that will accrue to the shareholder. Although financial ratio analysis is well-developed and the actual ratios are well-known, practicing financial analysts often develop their own measures for particular industries and even individual companies. Analysts will often differ drastically in their conclusions from the same ratio analysis.
Value managers try to find companies trading at less than their “intrinsic value”, the price the underlying company is worth. In other words, they try to by the stock as cheaply as possible. In buying stocks as cheaply as possible, they hope to outperform in the long term, as their undervalued stocks return to higher valuation levels. They also believe that when they make mistakes, they have a more limited downside, since they paid a cheap price for the stock to start with. Value managers use financial analysis to calculate yardsticks of a stock’s worth. A classic value manager would focus on: a low “P/E ratio” or price-to-earnings ratio (market price divided by earnings) which indicates that the stock is cheaply valued compared to earnings; a low “price-to-book” ratio (market price divided by accounting book value) which indicates that the stock is cheap compared to its historical accounting value; and a high dividend yield (dividend divided by market price) which shows that the stock pays a high cash yield on its price. Growth managers invest in the stocks of companies with rapidly growing sales and earnings. They believe that the stock price of this type of company will increase quickly as well, reflecting the strong growth of these companies. They do not focus on the valuation of these companies, preferring to examine their industries, management and growth potential. In aggregate, they think that the strong growth of these stocks will outweigh their valuations over a longer period of time. Obviously, growth managers focus on industries with strong growth such as technology and computer companies. The recent growth of the Internet has made Internet companies such as Yahoo! and Netscape favourites of growth investors Core managers or “closet indexers” focus on security selection, but try to maintain the same weightings as the index that they are compared to. They use the same valuation techniques as value and growth managers, but they don’t want to make their portfolios appreciably different from the index or other managers. There are a couple of reasons for this. The most important is relative performance. Relative performance means how a manager looks versus the market index they are compared to. Managers generally try to beat the index they are being compared to. If the manager’s portfolio is very different from the index, the manager will perform quite differently. If the manager’s performance is good, then there is little problem. When the manager under performs, the clients are not very happy or patient. So managers keep their portfolios similar to the index or other managers, expecting to be not to different from the index or other managers. The other reason is that clients, sales representatives and consultants want their manager’s performance to be similar to the index or other managers. Client often don’t want the best performance, but “conservative” management, meaning performance fairly similar to published performance statistics. Financial sales representatives want their clients to be happy and explaining wide performance differentials between client performance and published market and performance statistics takes a lot of time. Consultants want the manager’s performance to be similar to the index they are being measured against because they have done “asset planning” studies which are based on the performance of that index. This means that there is a large group, perhaps the majority of managers, who try to construct portfolios that will perform similarly to indexes and other managers. These core or “closet index” managers will pick the best stocks from an industry grouping. For example, if there are twenty-five stocks in an industry group that is 20% of the market index, the manager might select the best four at a 5% weight. Since most stocks in an industry tend to track each other in performance, the manager will have much the same performance in this portion of her portfolio as the index. By implementing this strategy for the significant industry groups in an index, the manager will obtain very similar performance to the index. Hopefully, by using financial analysis and valuation techniques to choose the best stocks from the index groups, the manager will outperform the index by a reasonable margin.
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