I wonder ... A long time ago a friend of mine made good cash by investing in Starbucks and Microsoft. How did he predict their success? His advice was simple, if you like a company, believe in that company's product or service, and like their culture, then you should invest in them. Hmmm ... in hind-sight it sounds to me like he was talking about their brand (oh, and I wish I'd done it at the same time)!
So, I thought I'd do blog a comparison of financial ratios to brand health. Today, I'm poking at financial ratios. Armed only with my own dated knowledge of ratios, and Google (which quickly led me to some good sources, cited below), I am happy to present for your reading pleasure ...
Basic Financial Ratios 101.
There are a wide variety of financial ratios that help to give you some idea of a firm's success. These can pretty much all be computed from basic information provided in annual statements, or are already publicly available on a wide array of websites. Ratios provide a snapshot of a company's performance. On its own an individual ratio won't tell you anything. Even when you get all the ratios for a given company at a given time, they still won't tell you anything.
Ratios are really only valuable when they are compared with other snapshots in time or wih other ratios from other similar companies, other similar industries, and so forth. Additionally, you need to have the context of what the company's strategy is and what they are trying to achieve. that will tell you why the ratios are what they are, and let you know if they should be what they are. In that light, here are some of the most common financial ratios:
- Liquidity Ratios --> provide information about a firm's ability to meet its short-term financial obligations and pay debt. Among Liquidity ratios are the Current Ratio (Current Assets divided by Current Liabilities). A higher current ratio reduces a lender's risk, while a lower current ratio indicates that more of the firm's assets are working to grow the business. Alternatively, an Operating Cash Flow Ratio calculation provides a much more conservative view of a firm's liquidity ((Cash + Marketable Securities) divided by Current Liabilities).
- Asset Turnover Ratios (or Efficiency Ratios, or Asset Utilization Ratios, or Asset Management Ratios, or Activity Ratios) --> indicate how well the firm uses its assets. One measure of Asset Turnover is Average Inventory Turnover (Average daily cost of goods sold in a period divided by the Average Inventory in that same period, or Annual Cost of Goods Sold divided by 365). The appropriate ratio value and its meaning varies dramatically by firm and industry.
- Financial Leverage Ratios or Debt Ratios --> try to tell the story of the long-term solvency of the firm. For instance, the Debt Ratio (Total Liabilities divided by Total Assets) or the Debt-to-Equity Ratio (Total Debt divided by Total Equity).
- Profitability Ratios --> include several different measures of how well a firm generates profits and controls its expenses. These include the simple Gross Profit Margin (Sales less the Cost of Goods Sold), which focuses on the firm's cost of goods sold, but does not include other costs. More complex ratios are the Return on assets (Net Income divided by Total Assets) which is a measure of how effectively the firm's assets are being used to generate profits, and Return on Equity (Net Income divided by Shareholder Equity) which similarly measures how effectively the investor's cash is earning profits.
- Market Ratios --> measure investor response to owning a company's stock. For instance, Earnings per Share is an often-quoted ratio (Expected Earnings divided by Number of Shares issued).
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