FUNDAMENTAL ANALYSIS
(Industry and Company Analysis)
ANALYSIS OF FINANCIAL RATIOS (A PART OF COMPANY ANALYSIS)
Analysts use financial ratios because numbers in isolation typically convey little meaning. Knowing that a firm earned a net income of $100,000 is less informative than also knowing the sales figure that generated this income ($1 million or $10 million) and the assets or capital committed to the enterprise. Thus, ratios are intended to provide meaningful relationships between individual values in the financial statements.
Because the major financial statements include numerous individual items, it is possible to produce a vast number of potential ratios, many of which will have little value. Therefore, you want to limit your examination to the most relevant ratios and categorize them into groups that will provide information on important economic characteristics of the firm. It is also important to recognize the need for relative analysis.
Importance of Relative Financial Ratios
Just as a single number from a financial statement is of little use, an individual financial ratio has little value except in relation to comparable ratios for other entities. That is, only relative financial ratios are relevant. The important comparisons examine a firm’s performance relative to
➤ The aggregate economy
➤ Its industry or industries
➤ Its major competitors within the industry
➤ Its past performance (time-series analysis)
The comparison to the aggregate economy is important because almost all firms are influenced by the economy’s expansions and contractions (recessions) in the business cycle. For example, it is unreasonable to expect an increase in the profit margin for a firm during a recession; a stable margin might be encouraging under such conditions. In contrast, no change or a small increase in a firm’s profit margin during a major business expansion may be a sign of weakness. Comparing a firm’s financial ratios relative to a similar set of ratios for the economy will also help you to understand how a firm reacts to the business cycle and will help you estimate the future performance of the firm during subsequent business cycles.
Probably the most significant comparison relates a firm’s performance to that of its industry. Different industries affect the firms within them differently, but this company-industry relationship is always significant. The industry effect is strongest for industries with homogeneous products, such as steel, rubber, glass, and wood products, because all firms within these industries experience coincidental shifts in demand. In addition, these firms employ fairly similar technology and production processes. For example, even the best-managed steel firm experiences a decline in sales and profit margins during a recession. In such a case, the relevant question is not whether sales and margins declined but how bad was the decline and how did the firm perform relative to other steel firms? As part of this, you should examine an industry’s performance relative to aggregate economic activity to understand how the industry responds to the business cycle. When comparing a firm’s financial ratios to industry ratios, you may not feel comfortable using the average (mean) industry value when there is wide variation among individual firm ratios within the industry. Alternatively, you may believe that the firm being analyzed is not typical—that is, it has a unique component. Under these conditions, a cross-sectional analysismay be appropriate, in which you compare the firm to a subset of firms within the industry thatare comparable in size or characteristics. As an example, if you were interested in Kroger, youwould want to compare its performance to that of other national food chains rather than someregional chains or specialty food chains.
Another practical problem with comparing a firm’s ratios to an industry average is that manylarge firms are multiproduct and multi-industry in nature. Inappropriate comparisons can arisewhen a multi-industry firm is evaluated against the ratios from a single industry. Two approachescan help mitigate this problem. First, you can use a cross-sectional analysis by comparing the firmagainst a rival that operates in many of the same industries. Second, you can construct composite
industry average ratios for the firm. To do this, the firm’s annual report or 10-K filing is used toidentify each industry in which the firm operates and the proportion of total firm sales derivedfrom each industry. Following this, composite industry average ratios are constructed by computingweighted average ratios based on the proportion of firm sales derived from each industry.
Finally, you should examine a firm’s relative performance over time to determine whether itis progressing or declining. This time-series analysis is helpful when estimating future performance.For example, some analysts calculate the average of a ratio for a 5- or 10-year periodwithout considering the trend. This can result in misleading conclusions. For example, an averagerate of return of 10 percent can be based on rates of return that have increased from 5 percentto 15 percent over time, or it can be based on a series that begins at 15 percent and declinesto 5 percent. Obviously, the difference in the trend for these series would have a major impacton your estimate for the future. Ideally, you want to examine a firm’s time series of relativefinancial ratios compared to its industry and the economy.
COMPUTATION OF FINANCIAL RATIOS
We divide the financial ratios into five major categories that will help us understand the important economic characteristics of a firm. In this section, we focus on describing the various ratios and computing them using Walgreens data. Comparative analysis of Walgreens ratios with the economy and industry will be discussed in a later section.
Our example company is Walgreen Co., the largest retail drugstore chain in the United States. It operates 3,165 drugstores in 43 states and Puerto Rico. General merchandise accounts for 26 percent and pharmacy generates over 55 percent of total sales. The firm leads its industry (retail drugstores) in sales, profit, and store growth. The firm’s goal is to be America’s most convenient and technologically advanced health care retailer. It takes great pride in its steady sales and earnings growth that has been reflected in outstanding stock performance—for example, dividends have been increased in each of the past 25 years and, since 1980, the stock has been split two-for-one seven times.
The five categories are
1. Common size statement
2. Internal liquidity (solvency)
3. Operating performance
a. Operating efficiency
b. Operating profitability
4. Risk analysis
a. Business risk
b. Financial risk
c. Liquidity risk
5. Growth analysis
Common-Size Statements
Common-size statements “normalize” balance sheet and income statement items to allow easier comparison of different-size firms. A common-size balance sheet expresses all balance sheet accounts as a percentage of total assets. A common-size income statement expresses all income statement items as a percentage of sales Common-size ratios are useful to quickly compare two different-size firms and to examine trends over time within a single firm. Common-size statements also give an analyst insight into the structure of a firm’s financial statements—that is, the proportion of assets that are liquid, the proportion of liabilities that are short-term obligations, or the percentage of sales consumed by production costs. For example, for Walgreens, the common-size balance sheet shows a small decline in the percent of current assets and a steady increase in the proportion of net property. Alternatively, the commonsize income statement in Exhibit shows algreens’ cost of goods sold was relatively stable during the five years with a small increase overall in proportion to sales. As a result of this stability combined with a consistent small decline in the ratio for selling, general, and administrative (SGA) expenses, the firm has experienced an overall increase in its operating profit margin before and after taxes. The ability of Walgreens to experience strong growth in sales (over 14 percent a year) and an overall increase in its profit margin is very impressive.
Evaluating internal liquidity
Internal liquidity (solvency) ratios indicate the ability of the firm to meet future short-term financial obligations. They compare near-term financial obligations, such as accounts payable or notes payable, to current assets or cash flows that will be available to meet these obligations.
Internal Liquidity Ratios
Current Ratio Clearly the best-known liquidity measure is the current ratio, which examines the relationship between current assets and current liabilities as follows:
For Walgreens, the current ratios were (all ratios are computed using dollars in 1,000s):
These current ratios experienced a small decline during the three years and are consistent with the “typical’ current ratio. As always, it is important to compare these values with similar figures for the firm’s industry and the aggregate market. If the ratios differ from the industry results, it is necessary to determine what might explain it. This comparative analysis is considered in a subsequent section.
Quick Ratio Some observers believe you should not consider total current assets when gauging the ability of the firm to meet current obligations because inventories and some other assets included in current assets might not be very liquid. As an alternative, they prefer the quick ratio, which relates current liabilities to only relatively liquid current assets (cash items and accounts receivable) as follows:
Walgreens’ quick ratios were:
These quick ratios for Walgreens were small, but were fairly constant over the three years. As before, you should compare these values relative to other firms in the industry and to the aggregate economy. When possible, you should question management regarding the reason for these relatively low liquidity ratios (e.g., small receivables due to heavy cash sales?).
Cash Ratio The most conservative liquidity ratio is the cash ratio, which relates the firm’s cash and short-term marketable securities to its current liabilities as follows:
Walgreens’ cash ratios were:
The cash ratios during these three years have been quite low and they would be cause for concern except that such cash ratios are typical for a fast-growing retailer with larger inventories being financed by accounts payable to its suppliers. In addition, the firm has strong lines of credit available on short notice at various banks. Still, as an investor, you would want to confirm how the firm can justify such a low ratio and how it is able to accomplish this.
Receivables Turnover In addition to examining total liquid assets relative to near-term liabilities, it is useful to analyze the quality (liquidity) of the accounts receivable. One way to do this is to calculate how often the firm’s receivables turnover, which implies an average collection period. The faster these accounts are paid, the sooner the firm gets the funds that can be used to pay off its own current liabilities. Receivables turnover is computed as follows:
Analysts typically derive the average receivables figure from the beginning receivables figure plus the ending value divided by two. Walgreens’ receivables turnover ratios were:
It is not possible to compute a turnover value for 1999 because the tables used do not include a beginning receivables figure for 1999 (that is, we lack the ending receivables figure for 1998).
Given these annual receivables turnover figures, an average collection period is as follows:
These results indicate that Walgreens currently collects its accounts receivable in about 10 days on average, and this collection period has increased slightly over the recent five years. To determine whether these receivable collection numbers are good or bad, it is essential that they be related to the firm’s credit policy and to comparable collection figures for other firms in the industry. The point is, the receivable collection period value varies dramatically for different firms (e.g., from 10 to over 60) and it is mainly due to the product and the industry. Such an analysis would indicate similar rapid collection periods for other drugstore chains since this is basically a cash business for the majority of sales. Still, a significant change has occurred for drugstores because about 90 percent of pharmacy sales are to a third party (i.e., these pharmacy sales are reimbursed by a managed-care company), which, in turn, generates a receivable.
The receivables turnover is one of the ratios where you do not want to deviate too much from the norm. For example, in an industry where the “normal” collection period is 40 days, a collection period of 80 days would indicate slow-paying customers, which increases the capital tied up in receivables and the possibility of bad debts. Therefore, you would want the firm to be somewhat below the norm (for example, 35 days versus 40 days). At the same time, a figure substantially below the norm, such as 20 days, might indicate overly stringent credit terms relative to your competition, which could be detrimental to sales.
Inventory Turnover Another current asset that should be examined in terms of its liquidity is inventory based upon the firm’s inventory turnover and the implied processing time. Inventory turnover can be calculated relative to sales or cost of goods sold. The preferred turnover ratio is relative to cost of goods sold (CGS) because CGS does not include the profit implied in sales.
For Walgreens, the inventory turnover ratios are as follows:
Given the turnover values, you can compute the average inventory processing time as follows:
Although this seems like a low turnover figure, it is encouraging that the inventory processing period is very stable and has declined slightly compared to the longer run period. Still, it is essential to examine this figure relative to an industry norm and/or the firm’s prime competition. Notably, it will also be affected by the products carried by the chain—for instance, if a drugstore chain adds high-profit-margin items, such as cosmetics and liquor, these products may have a lower turnover.
As with receivables, you do not want an extremely low inventory turnover value and long processing time because this implies that capital is being tied up in inventory and could signal obsolete inventory (especially for firms in the technology sector). Alternatively, an abnormally high inventory turnover and a very short processing time relative to competitors could mean inadequate inventory that could lead to outages, backorders, and slow delivery to customers, which would eventually have an adverse effect on sales.
Cash Conversion Cycle A very useful measure of overall internal liquidity is the cash conversion cycle, which combines information from the receivables turnover, the inventory turnover, and the accounts payable turnover. The point is, cash is tied up in assets for a certain number of days. Specifically, cash is committed to receivables for the collection period and is also tied up for a number of days in inventory—the inventory processing period. At the same time, the firm receives an offset to this capital commitment from its own suppliers, who provide interest-free loans to the firm by carrying the firm’s payables. Specifically, the payables payment period is equal to 365/the payables turnover ratio. In turn, the payables turnover ratio is equal to:
For Walgreens, the payables turnover ratio is:
Therefore, the cash conversion cycle for Walgreens equals:
Walgreens has experienced a small decline in its receivables days, it has been stable regarding its inventory processing days, and it is paying its bills at the same speed. Overall, the result has been a small decrease in its cash conversion cycle. Although the overall cash conversion cycle appears to be quite good (about 46 days), as always, you should examine the firm’s long-term trend and compare it to other drugstore chains.
Evaluating operating performance
The ratios that indicate how well the management is operating the business can be divided into two subcategories:
(1) operating efficiency ratios and
(2) operating profitability ratios.
Efficiency ratios examine how the management uses its assets and capital, measured in terms of the dollars of sales generated by various asset or capital categories. Profitability ratios analyze the profits as a percentage of sales and as a percentage of assets and capital employed.
Operating Efficiency Ratios
Total Asset Turnover The total asset turnover ratio indicates the effectiveness of the firm’s use of its total asset base (net assets equals gross assets minus depreciation on fixed assets). It is computed as follows:
Walgreens’ total asset turnover values were:
It is essential that you compare this ratio to that of other firms in an industry because this particular ratio varies substantially between industries. For example, total asset turnover ratios range from about 1 (or less) for large, capital-intensive industries (steel, autos, and other heavy manufacturing companies) to over 10 for some retailing or service operations. This ratio can also be affected by the use of leased facilities.
Again, you should consider a range of turnover values consistent with the industry. It is poor management to have an exceedingly high asset turnover relative to your industry because this might imply too few assets for the potential business (sales), or it could be due to the use of outdated, fully depreciated assets. It is equally poor management to have a low relative asset turnover because this implies tying up capital in an excess of assets relative to the needs of the firm.