Investors often use accounting statements to evaluate a firm in one of two ways:
- Compare the firm with itself by analyzing how the firm has changed over time.
- Compare the firm to other similar firms using a common set of financial ratios.
Information used here comes from the income statement.
This tells us a firm’s ability to sell a product for more than cost of producing it.
This reveals how much a company earns before interest and taxes from each dollar of sales. We can similarly compute a firm’s EBIT margin = (EBIT/Sales). By comparing operating or EBIT margins across firms within an industry, we can assess the relative efficiency of the firms’ operations.
Net Profit Margin
The net profit margin shows the fraction of each dollar in revenues that is available to equity holders after the firm pays interest and taxes. Be careful when comparing net profit margins: While differences in net profit margins can be due to differences in efficiency, they can also result from differences in leverage, which determines the amount of interest expense, as well as differences in accounting assumptions.
Information used here comes from the balance sheet.
Used to assess whether the firm has sufficient working capital to meet its short-term needs.
A more stringent test of the firm’s liquidity is the quick ratio, which compares only cash and “near cash” assets, such as short-term investments and accounts receivable, to current liabilities.
The most stringent liquidity ratio is to look at a firm’s cash position.
Working Capital Ratios
Accounts Receivable Days
To evaluate the speed at which a company turns sales into cash, firms compute the number of days’ worth of sales accounts receivable represents.
Accounts Payable Days
The number of days’ worth of costs accounts payable represents.
The number of days’ worth of costs inventory represents.
The number of times average inventory is sold during the year. Similarly, accounts receivable turnover = (annual sales/accounts receivable) and accounts payable turnover = (annual cost of sales/accounts payable).
Interest Coverage Ratios
Lenders often assess a firm’s ability to meet its interest obligations by comparing its earnings with its interest expenses using an interest coverage ratio. One common ratio to consider is the firm’s EBIT as a multiple of its interest expenses. A high ratio indicates that the firm is earning much more than is necessary to meet its required interest payments.
Depreciation and amortization expenses are deducted when computing EBIT, but they are not actually cash expenses for the firm. Consequently, financial analysts often compute a firm’s earnings before interest, taxes, depreciation, and amortization, or EBITDA, as a measure of the cash a firm generates from its operations and has available to make interest payments:
An important piece of information that we can learn from a firm’s balance sheet is the firm’s leverage, or the extent to which it relies on debt as a source of financing.
We can calculate the debt–equity ratio using either book or market values for equity and debt. It is more informative to compare the firm’s debt to the market value of its equity.
This is the fraction of the firm financed by debt. This can be computed with book or market values.
Debt-to-Enterprise Value Ratio
While leverage increases the risk to the firm’s equity holders, firms may also hold cash reserves in order to reduce risk. Thus, another useful measure to consider is the firm’s net debt, or debt in excess of its cash reserves:
We can use the concept of net debt to compute the firm’s debt-to-enterprise value ratio:
A final measure of leverage is a firm’s equity multiplier, measured in book value terms.
This measure captures the amplification of the firm’s accounting returns that results from leverage.
The market value equity multiplier, which is generally measured as the following, indicates the amplification of shareholders’ financial risk that results from leverage.
This tells how many times the earnings is a shareholder willing to pay for a share. This depends on the industry; faster growing industries tend to have higher P/E ratios, and vice versa. It also depends on risk; riskier firms have lower P/E ratios.
The P/E ratio is sensitive to the firm’s choice of leverage. It’s hard to use when comparing two firms with different leverages. We can avoid this by assessing the market value using valuation ratios based on the firm’s enterprise value. Common ratios include the ratio of enterprise value to revenue, or enterprise value to operating income, EBIT, or EBITDA. These ratios compare the value of the business to its sales, operating profits, or cash flow.
The P/E ratio, or ratios to EBIT or EBITDA, are not meaningful if the firm’s earnings are negative. In that case, it’s common to look at the firm’s enterprise value relative to sales. However, this is risky because earnings could be negative due to the underlying business model being fundamentally flawed.
Return on Equity
The ROE provides a measure of the return that the firm has earned on its past investments. A high ROE may indicate the firm is able to find investment opportunities that are very profitable.
Return on Assets
ROA has the benefit that it is less sensitive to leverage than ROE. However, it is sensitive to working capital – for example, an equal increase in the firm’s receivables and payables will increase total assets and thus lower ROA.
Return on Invested Capital
To avoid the problem with the ROA, we can consider the firm’s return on invested capital (ROIC):
The return on invested capital measures the after-tax profit generated by the business itself, excluding any interest expenses (or interest income), and compares it to the capital raised from equity and debt holders that has already been deployed (i.e., is not held as cash). Of the three measures of operating returns, ROIC is the most useful in assessing the performance of the underlying business.
The DuPont Identity
We can gain further insight into a firm’s ROE using a tool called the DuPont Identity, which expresses the ROE in terms of the firm’s profitability, asset efficiency, and leverage:
The first two terms together determine the firm’s return on assets. We compute ROE by multiplying by a measure of leverage called the equity multiplier, which indicates the value of assets held per dollar of shareholder equity. The greater the firm’s reliance on debt financing, the higher it will be.