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304-Interpreting the Numbers
  Course 304:
  Interpreting the Numbers
  In the preceding three lessons, we discussed each of the three main financial
  statements. You learned about the different components of the income statement
  and how to determine if a company is profitable. We talked about the
  distinction between assets, liabilities, and shareholders' equity and where to
  find them on the balance sheet. Finally, we went over the statement of cash
  flows to figure how much cash a company uses or makes from its operating,
  investing, and financing activities.
  
  But now that you have this knowledge about each of the financial statements,
  how do you, as an investor, use it?
  
  In this lesson we'll apply what you've learned so far in a process called
  financial statement analysis. Financial statement analysis looks to explain,
  often through financial ratios, the important relationships among the
  different numbers included in the financial statements. The ultimate goal of
  financial statement and ratio analysis is to help you interpret the numbers
  and come up with a clear picture of a company's financial performance and
  condition.
  
  Before we jump in, we should inform you that the following ratios are for
  non-financial companies only. Financial companies, such as banks or insurance
  companies, have unique characteristics. As a result, their financial
  statements look much different than those of most other companies.
  
  
  How to Use Financial Ratios
  We've touched on some of the ratios mentioned here in earlier lessons, but
  this lesson will give you a comprehensive look at the most important numbers
  to key in on. Some ratios can be useful by themselves. Others are completely
  useless when considered without context. Typically, financial ratios provide
  the most benefit when they are compared with other identical ratios.
  
  A company's ratios are used comparatively in two main fashions: over time and
  against other companies. Comparing the same ratios for a firm over time is a
  great way to identify a company's trends. If certain ratios are steadily
  improving, it may suggest an improvement in a company's operations or
  financial situation; conversely, if certain ratios seem to be getting worse,
  it may highlight some troubling prospects about the firm.
  
  It's also important to compare a company's ratios against those of others in
  the industry. A company's ratios may be improving over time, but how do they
  stack up against their peers' ratios? If they aren't as rosy as those of
  competitors, this may indicate that the company isn't as well positioned or
  managed as well as other industry players.
  
  At Morningstar, we evaluate many ratios as we perform our analyses. Four of
  the major types we consider are efficiency, liquidity, leverage, and
  profitability ratios. As we describe some of the main ratios within each
  category, we'll discuss what each one attempts to measure and what changes in
  them may indicate.
  
  
  Efficiency Ratios
  No matter what kind of business a company is in, it must invest in assets to
  perform its operations. Efficiency ratios measure how effectively the company
  utilizes these assets, as well as how well it manages its liabilities.
  
  Inventory Turnover. Inventory turnover illustrates how well a company manages
  its inventory levels. If inventory turnover is too low, it suggests that a
  company may be overstocking or overbuilding its inventory or that it may be
  having issues selling products to customers. All else equal, higher inventory
  turnover is better.
  
  Inventory Turnover = (Cost of Sales) / (Average Inventory)
  
  Accounts Receivable Turnover. The accounts receivable turnover ratio measures
  how effective the company's credit policies are. If accounts receivable
  turnover is too low, it may indicate the company is being too generous
  granting credit or is having difficulty collecting from its customers. All
  else equal, higher receivable turnover is better.
  
  Accounts Receivable Turnover = Revenue / (Average Accounts Receivable)
  
  Accounts Payable Turnover. You'll notice that the accounts payable turnover
  ratio uses a liability in the equation rather than an asset, as well as an
  expense rather than revenue. Accounts payable turnover is important because it
  measures how a company manages paying its own bills. High accounts payable
  turnover may be a signal that a firm isn't receiving very favorable payment
  terms from its own suppliers. All else equal, lower payable turnover is
better.
  
  Accounts Payable Turnover = (Cost of Sales) / (Average Accounts Payable)
  
  Total Asset Turnover. Total asset turnover is a catch-all efficiency ratio
  that highlights how effective management is at using both short-term and
  long-term assets. All else equal, the higher the total asset turnover, the
  better.
  
  Total Asset Turnover = (Revenue) / (Average Total Assets)
  
  
  Liquidity Ratios
  In a nutshell, a company's liquidity is its ability to meet its near-term
  obligations, and it is a major measure of financial health.
  
  Liquidity can be measured through several ratios.
  
  Current ratio. The current ratio is the most basic liquidity test. It
  signifies a company's ability to meet its short-term liabilities with its
  short-term assets. A current ratio greater than or equal to one indicates that
  current assets should be able to satisfy near-term obligations. A current
  ratio of less than one may mean the firm has liquidity issues.
  
  Current Ratio = (Current Assets) / Current Liabilities
  
  Quick Ratio. The quick ratio is a tougher test of liquidity than the current
  ratio. It eliminates certain current assets such as inventory and prepaid
  expenses that may be more difficult to convert to cash. Like the current
  ratio, having a quick ratio above one means a company should have little
  problem with liquidity. The higher the ratio, the more liquid it is, and the
  better able the company will be to ride out any downturn in its business.
  
  Quick Ratio = (Cash Accounts Receivable Short-Term or Marketable
  Securities) / (Current Liabilities)
  
  Cash Ratio. The cash ratio is the most conservative liquidity ratio of all. It
  only measures the ability of a firm's cash, along with investments that are
  easily converted into cash, to pay its short-term obligations. Along with the
  quick ratio, a higher cash ratio generally means the company is in better
  financial shape.
  
  Cash Ratio = (Cash Short-Term or Marketable Securities) / (Current
  Liabilities)
  
  
  Leverage Ratios
  A company's leverage relates to how much debt it has on its balance sheet, and
  it is another measure of financial health. Generally, the more debt a company
  has, the riskier its stock is, since debtholders have first claim to a
  company's assets. This is important because, in extreme cases, if a company
  becomes bankrupt, there may be nothing left over for its stockholders after
  the company has satisfied its debtholders.
  
  Debt/Equity. The debt/equity ratio measures how much of the company is
  financed by its debtholders compared with its owners. A company with a ton of
  debt will have a very high debt/equity ratio, while one with little debt will
  have a low debt/equity ratio. Assuming everything else is identical, companies
  with lower debt/equity ratios are less risky than those with higher such
  ratios.
  
  Debt/Equity = (Short-Term Debt Long-Term Debt) / Total Equity
  
  Interest Coverage. If a company borrows money in the form of debt, it most
  likely incurs interest charges on it. (Money isn't free, after all!) The
  interest coverage ratio measures a company's ability to meet its interest
  obligations with income earned from the firm's primary source of business.
  Again, higher interest coverage ratios are typically better, and interest
  coverage close to or less than one means the company has some serious
  difficulty paying its interest.
  
  Interest Coverage = (Operating Income) / (Interest Expense)
  
  
  Profitability Ratios
  How good is a company at running its business? Does its performance seem to be
  getting better or worse? Is it making any money? How profitable is it compared
  with its competitors? All of these very important questions can be answered by
  analyzing profitability ratios.
  
  Gross Margin. You'll recall from our earlier discussion of the income
  statement that gross profit is simply the difference between a company's sales
  of goods or services and how much it must pay to provide those goods or
  services. Gross margin is simply the amount of each dollar of sales that a
  company keeps in the form of gross profit, and it is usually stated in
  percentage terms. The higher the gross margin, the more of a premium a company
  charges for its goods or services. Keep in mind that companies in different
  industries may have vastly different gross margins.
  
  Gross Margin = (Gross Profit) / (Sales)
  
  Operating Margin. Operating margin captures how much a company makes or loses
  from its primary business per dollar of sales. It is a much more complete and
  accurate indicator of a company's performance than gross margin, since it
  accounts for not only the cost of sales but also the other important
  components of operating income we discussed in Lesson 301, such as marketing
  and other overhead expenses.
  
  Operating Margin = (Operating Income or Loss) / Sales
  
  Net Margin.
  Net margin considers how much of the company's revenue it keeps when all
  expenses or other forms of income have been considered, regardless of their
  nature. While net margin is important to take note of, net income often
  contains quite a bit of "noise," both good and bad, which does not really have
  much to do with a company's core business.
  
  Net Margin = (Net Income or Loss) / Sales
  
  Free Cash Flow Margin. In Lesson 303, we discussed the concept and importance
  of free cash flow. The free cash flow margin simply measures how much per
  dollar of revenue management is able to convert into free cash flow.
  
  Free Cash Flow Margin = (Free Cash Flow) / Sales
  
  Return on Assets (ROA). Return on assets measures a company's ability to turn
  assets into profit. (This may sound similar to the total assets turnover ratio
  discussed earlier, but total assets turnover measures how effectively a
  company's assets generate revenue.)
  
  Return on Assets = (Net Income Aftertax Interest Expense) / (Average Total
  Assets)
  
  You'll notice that we are adding back the company's aftertax interest expense
  to net income in the calculation. Why is that? Return on assets measures the
  profitability a company achieves on all of its assets, regardless if they are
  financed by equity holders or debtholders; therefore, we add back in what the
  debtholders are charging the company to borrow money. Why are we adding
  interest back in on an "aftertax" basis? Interest expense is one of the many
  line items that are either added to or subtracted from revenue to calculate
  the pretax income amount. This pretax income amount is then taxed to come up
  with net income. Thus, when the income-reducing effect of interest expense is
  ultimately filtered down to net income, it is on an aftertax basis.
  
  A company's aftertax interest expense is easy to determine. First, determine
  its tax rate by dividing its income tax expense by its pretax income. Then
  plug that figure into the following formula: Aftertax Interest Expense = (1 -
  Tax Rate) x (Interest Expense)
  
  Return on assets is generally stated in percentage terms, and higher is
  better, all else equal.
  
  Return on Equity (ROE). Return on equity is a straightforward ratio that
  measures a company's return on its investment by shareholders. Like all of the
  profitability ratios we've discussed, it is usually stated in percentage
  terms, and higher is better.
  
  Return on Equity = (Net Income) / (Average Shareholders' Equity)
  
  
  The Bottom Line
  In this lesson, we began to apply what we had learned about the financial
  statements in the previous three lessons. We talked about the use of financial
  ratios and the importance of considering them in a comparative context. We
  covered several types of ratios, including efficiency, liquidity, leverage,
  and profitability ratios. By studying the concepts outlined above and
  completing the exercises that follow, you'll be well on your way toward
  understanding how to interpret a company's financial statements and analyzing
  a company for investment purposes.