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# Ratio Analysis of Financial Statements

Ratio analysis is the core tool for the fundamental analysis of a company. It allows an evaluation of the current financial state of a company without being handicapped by the magnitude of the numbers. It is also useful in evaluating market performance.

Ratios permit you to compare a company with its historical metrics.  Is it doing better? How much better? If not better, why not?

Equally important, it allows a head-to-head comparison of companies regardless of their size from both a fundamental and technical perspective.

## What is Ratio Analysis

Ratio analysis is the conversion of data from financial statements to ratios that facilitate analysis of the company. In the analysis of companies, the magnitude of the numbers is important on occasion (market cap for example). But to compare value, financial strength, market performance, sentiment, growth, or quality or to detect fraud, ratios are critical.

For example, if a company has sales of \$500 million and 100 million shares of stock outstanding, the sales per share would be \$500/100 or \$5. Once we have a sales per share value for everyone, this company can be compared to other companies on a sales per share basis whether they have \$50 billion in sales or \$125 million in sales.  Not a very useful metric, but it illustrates the point.

## Three Types of Ratios

### 1. Per share ratios

While sales per share may not be particularly useful as a stand-alone metric, earnings per share (EPS) is a widely followed metric. Not only the current and historical earnings of a company, but the estimates of future earnings generated by analysts following the company.

Per share metrics are often turned into valuation metrics using per share ratio from a financial statement and the market price of a share of stock.

Using the sales per share example above, if the shares are selling for \$7.50 a share, you would be paying \$7.50 for every \$5.00 of sales.  The resulting ratio, 1.5, is called the Price to Sales (P/S) ratio and tells us how much we would be paying for each dollar of sales. All else being equal, would you rather pay \$1.50 for each dollar of sales or \$1.05 for each dollar of sales? Pretty easy decision.

Similarly, EPS becomes the Price to Earnings (P/E) ratio.

Another approach is to consider what the company P/S ratio was in the past. If it has been \$1.95 historically, maybe \$1.50 isn’t too bad. Yet another approach is to compare the P/S to the mean or median P/S of the industry or sector.

Generally, per share ratios created using a per share metric and share price reflect valuation.

To illustrate the effectiveness of using ratio analysis to segregate companies, consider the following performance chart.  It separates the companies of the S&P 500 into 5 equal groups by P/S every week from 1/2/1999 through 12/31/2016. The lowest 20% of P/S in a group, then the next 20%, and so on. Then it measures the performance of the stock price for the week. Each bar on the graph measures the collective performance of the group combined for the entire period of the test.

Using just a single per share ratio to separate the sheep and the goats doesn't look too bad. But it is not as good as it looks since most of us are not going to buy shares in 100 companies. This concept is developed further in ranking systems.

### 2. Percentages

Percentages are what most of us use to describe a change in a particular metric over time.

Suppose a company pays an annual dividend of \$2.00 but plans to increase the dividend by 10 cents. This is an increase of 5% in the annual dividend. Another company has the same 10 cent increase but the previous annual dividend was \$5.00, a 2% increase. The 5% may or may not be important in a dividend investing strategy, but if we rank companies passing our strategy screen by annual percent increase in dividends, it will be easy to compare.

In ratio analysis, percentages often reflect trends (positive or negative) of a single metric. They are not limited to change from some point in time, they can also be forward looking like changes in analyst predictions of earnings or sales.

Another common use of percentages is profitability. For example, if we say our strategy gained 14% last year, people will know what we mean. Similarly for losses.

If a company has net income of \$30 million and assets of \$1 billion, they would have a Return on Assets (ROA) of 3%. Once again, this allows for both historical and peer comparisons without regard to size.

Net and gross margins are further examples of profitability ratios derived from financial statements that are evaluated as percentages .

### 3. Other factors

In the ROA example above, income and assets are dissimilar metrics. In fact, income is listed on the Income Statement, and assets are on the Balance Sheet. Since the result is a percentage, it was included above.

However, not all ratios are converted to percentages.

Current ratio, a measure of a company’s ability to pay short-term debt, is the ratio of total current assets to total current liabilities. Even though assets and liabilities are dissimilar, it provides meaningful information. And once again, allows for comparison with the past and with peers regardless of their size.

This type of ratio often is a factor for examining financial strength. Meaning, can they pay their bills.

In cases where the market value of company stock and bonds is considered, the ratio may reflect valuation.

## Other Considerations

When considering ratios, it is important to understand that not all of the metrics involved are single line items from a financial statement. In many cases, metrics are composites of multiple metrics. Enterprise Value (EV) is a good example. It is becoming more widely used by retail investors and includes the market value of common and preferred securities, the minority interest, and total debt less the cash on hand. It represents the current value of the enterprise, not just the market cap.

It is also necessary to know for any particular ratio if a higher value is preferred or if a lower value is preferred. For our first example, P/S, lower is preferable. But for a current ratio, higher is preferable.

Just because lower is better for a valuation ratio like P/S, does not mean that for all valuation ratios lower is better. Some authors, particularly academics, use S/P, not P/S. For S/P, higher, not lower is preferable even though price per share and sales per share are still used to construct the ratio. Usually this is made clear when the ratio is introduced to the strategy or analysis. But check.

## Limitations of Ratio Analysis

Ratio analysis has some limitations imposed by the universe of stocks under consideration. One of the issues is comparing companies from the apples sector with companies from the oranges sector. Sometimes, and for some metrics, you just cannot compare apples and oranges.

Perhaps the simplest example is in the capitalization required to start or maintain a business. Far less capital is required to start a software company than is required to start an electric utility.

This is sometimes seen in strategy criteria where certain industries or sectors may be excluded. Rather than exclude, one workaround is to use industry relative or sector relative comparisons rather than absolute boundaries. That is, compare the ratio to an industry mean or median rather than to an absolute value.

The good news is that some screeners allow percentile and relative ranking; which is why we include it as a "nice to have" screener feature.

## Stock Screeners, Strategies and Ratios

Your investing strategies are driven by and define the data you need in stock screening tools. Most of the ratios will already be generated and exist as criteria in the better screeners.

If the ratio you need is not included but the components are, you will need a screener capable of generating a custom ratio with a formula. For example, suppose you want the ratio of (Sales for trailing 12 months) / EV. If both data points exist in the screener criteria and custom formulas are possible, you just build the ratio and included it in your screen. Otherwise, you would need to do all other screening and download the results (along with SalesTTM and EV) and do your ratio analysis in Excel.

Of course, you need to be able to export data from your screener if you want to do your ratio analysis in Excel.

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