## Stock Investing For Dummies, 5th Edition - Paul Mladjenovic (2016)

### Part VI. Appendixes

### Appendix B. Financial Ratios

Considering how many financial catastrophes have occurred in recent years (and continue to occur in the current headlines), doing your homework regarding the financial health of your stock choices is more important than ever. This appendix should be your go-to section when you find stocks that you’re considering for your portfolio. It lists the most common ratios that investors should be aware of and use. A solid company doesn’t have to pass all these ratio tests with flying colors, but at a minimum, it should comfortably pass the ones regarding profitability and solvency:

· **Profitability:** Is the company making money? Is it making more or less than it did in the prior period? Are sales growing? Are profits growing?

You can answer these questions by looking at the following ratios:

· Return on equity

· Return on assets

· Common size ratio (income statement)

· **Solvency:** Is the company keeping debts and other liabilities under control? Are the company’s assets growing? Is the company’s net equity (or net worth or stockholders’ equity) growing?

You can answer these questions by looking at the following ratios:

· Quick ratio

· Debt to net equity

· Working capital

While you examine ratios, keep these points in mind:

· Not every company and/or industry is the same. A ratio that seems dubious in one industry may be just fine in another. Investigate and check out the norms in that particular industry. (See __Chapter 13__ for details on analyzing sectors and industries.)

· A single ratio isn’t enough on which to base your investment decision. Look at several ratios covering the major aspects of the company’s finances.

· Look at two or more years of the company’s numbers to judge whether the most recent ratio is better, worse, or unchanged from the previous years’ ratios. Ratios can give you early warning signs regarding the company’s prospects. (See __Chapter 11__ for details on two important documents that list a company’s numbers — the balance sheet and the income statement.)

*Liquidity Ratios*

*Liquidity* is the ability to quickly turn assets into cash. Liquid assets are simply assets that are easy to convert to cash. Real estate, for example, is certainly an asset, but it’s not liquid because converting it to cash can take weeks, months, or even years. Current assets such as checking accounts, savings accounts, marketable securities, accounts receivable, and inventory are much easier to sell or convert to cash in a short period of time.

Paying bills or immediate debt takes liquidity. Liquidity ratios help you understand a company’s ability to pay its current liabilities. The most common liquidity ratios are the current ratio and the quick ratio; the numbers to calculate them are located on the balance sheet.

*Current ratio*

The current ratio is the most commonly used liquidity ratio. It answers the question, “Does the company have enough financial cushion to meet its current bills?” It’s calculated as follows:

Current ratio = Total current assets divided by Total current liabilities

If Schmocky Corp. (SHM) has $60,000 in current assets and $20,000 in current liabilities, the current ratio is 3, meaning the company has $3 of current assets for each dollar of current liabilities. As a general rule, a current ratio of 2 or more is desirable.

A current ratio of less than 1 is a red flag that the company may have a cash crunch that could cause financial problems. Although many companies strive to get the current ratio to equal 1, I like to see a higher ratio (in the range of 1–3) to keep a cash cushion should the economy slow down.

*Quick ratio*

The quick ratio is frequently referred to as the “acid-test” ratio. It’s a little more stringent than the current ratio in that you calculate it without inventory. I’ll use the current ratio example discussed in the preceding section. What if half of the assets are inventory ($30,000 in this case)? Now what? First, here’s the formula for the quick ratio:

Quick ratio = (Current assets less inventory) divided by Current liabilities

In the example, the quick ratio for SHM is 1.5 ($60,000 minus $30,000 equals $30,000, which is then divided by $20,000). In other words, the company has $1.50 of “quick” liquid assets for each dollar of current liabilities. This amount is okay. *Quick liquid assets* include any money in the bank, marketable securities, and accounts receivable. If quick liquid assets at the very least equal or exceed total current liabilities, that amount is considered adequate.

The acid-test that this ratio reflects is embodied in the question, “Can the company pay its bills when times are tough?” In other words, if the company can’t sell its goods (inventory), can it still meet its short-term liabilities? Of course, you must watch the accounts receivable as well. If the economy is entering rough times, you want to make sure that the company’s customers are paying invoices on a timely basis.

*Operating Ratios*

Operating ratios essentially measure a company’s efficiency. “How is the company managing its resources?” is a question commonly answered with operating ratios. If, for example, a company sells products, does it have too much inventory? If it does, that could impair the company’s operations. The following sections present common operating ratios.

*Return on equity (ROE)*

*Equity* is the amount left from total assets after you account for total liabilities. (This can also be considered a profitability ratio.) The *net equity* (also known as shareholders’ equity, stockholders’ equity, or net worth) is the bottom line on the company’s balance sheet, both geographically and figuratively. It’s calculated as

Return on equity (ROE) = Net income divided by Net equity

The *net income* (from the company’s income statement) is simply the total income less total expenses. Net income that isn’t spent, distributed in dividends, or used up increases the company’s net equity. Looking at net income is a great way to see whether the company’s management is doing a good job growing the business. You can check this out by looking at the net equity from both the most recent balance sheet and the one from a year earlier. Ask yourself whether the current net equity is higher or lower than the year before. If it’s higher, by what percentage is it higher?

For example, if SHM’s net equity is $40,000 and its net income is $10,000, its ROE is a robust 25 percent (net income of $10,000 divided by net equity of $40,000). The higher the ROE, the better. An ROE that exceeds 10 percent (for simplicity’s sake) is good (especially in a slow and struggling economy). Use the ROE in conjunction with the ROA ratio in the following section to get a fuller picture of a company’s activity.

*Return on assets (ROA)*

The return on assets (ROA) may seem similar to the ROE in the preceding section, but it actually gives a perspective that completes the picture when coupled with the ROE. The formula for figuring out the ROA is

Return on assets = Net income divided by Total assets

The ROA reflects the relationship between a company’s profit and the assets used to generate that profit. If SHM makes a profit of $10,000 and has total assets of $100,000, the ROA is 10 percent. This percentage should be as high as possible, but it will generally be less than the ROE.

Say that a company has an ROE of 25 percent but an ROA of only 5 percent. Is that good? It sounds okay, but a problem exists. An ROA that’s much lower than the ROE indicates that the higher ROE may have been generated by something other than total assets — debt! The use of debt can be a leverage to maximize the ROE, but if the ROA doesn’t show a similar percentage of efficiency, then the company may have incurred too much debt. In that case, investors should be aware that this situation can cause problems (see the section “__Solvency Ratios__,” later in this appendix). Better ROA than DOA!

*Sales-to-receivables ratio (SR)*

The sales-to-receivables ratio (SR) gives investors an indication of a company’s ability to manage what customers owe it. This ratio uses data from both the income statement (sales) and the balance sheet (accounts receivable, or AR). The formula is expressed as

Sales-to-receivables ratio = Sales divided by Receivables

Say that you have the following data for SHM:

· Sales in 2014 are $75,000. On 12/31/14, receivables stood at $25,000.

· Sales in 2015 are $80,000. On 12/31/15, receivables stood at $50,000.

Based on this data, you can figure out that sales went up 6.7 percent (sales in 2015 are $5,000 higher than 2014, and $5,000 is 6.7 percent of $75,000), but receivables went up 100 percent (the $25,000 in 2014 doubled to $50,000, which is a move up of 100 percent)!

In 2014, the SR was 3 ($75,000 divided by $25,000). However, the SR in 2015 sank to 1.6 ($80,000 divided by $50,000), or was nearly cut in half. Yes, sales did increase, but the company’s ability to collect money due from customers fell dramatically. This information is important to notice for one main reason: What good is selling more when you can’t get the money? From a cash flow point of view, the company’s financial situation deteriorated.

*Solvency Ratios*

*Solvency* just means that a company isn’t overwhelmed by its liabilities. Insolvency means “Oops! Too late.” You get the point. Solvency ratios have never been more important than they are now because the American economy is currently carrying so much debt. Solvency ratios look at the relationship between what a company owns and what it owes. The following sections discuss two of the primary solvency ratios.

*Debt-to-net-equity ratio*

The debt-to-net-equity ratio answers the question, “How dependent is the company on debt?” In other words, it tells you how much the company owes and how much it owns. You calculate it as follows:

Debt-to-net-equity ratio = Total liabilities divided by Net equity

If SHM has $100,000 in debt and $50,000 in net equity, the debt-to-net-equity ratio is 2. The company has $2 of debt to every dollar of net equity. In this case, what the company owes is twice the amount of what it owns.

Whenever a company’s debt-to-net-equity ratio exceeds 1 (as in the example), that isn’t good. In fact, the higher the number, the more negative the situation. If the number is too high and the company isn’t generating enough income to cover the debt, the business runs the risk of bankruptcy.

*Working capital*

Technically, working capital isn’t a ratio, but it does belong to the list of things that serious investors look at. *Working capital* measures a company’s current assets in relation to its current liabilities. It’s a simple equation:

Working capital = Total current assets minus Total current liabilities

The point is obvious: Does the company have enough to cover the current bills? Actually, you can formulate a useful ratio. If current assets are $25,000 and current liabilities are $25,000, that’s a 1-to-1 ratio, which is cutting it close. Current assets should be at least 50 percent higher than current liabilities (say, $1.50 to $1.00) to have enough cushion to pay bills and have some money for other purposes. Preferably, the ratio should be 2 to 1 or higher.

*Common Size Ratios*

Common size ratios offer simple comparisons. You have common size ratios for both the balance sheet (where you compare total assets) and the income statement (where you compare total sales):

· **To get a common size ratio from a balance sheet,** the total assets figure is assigned the percentage of 100 percent. Every other item on the balance sheet is represented as a percentage of total assets.

· Total assets equal 100 percent. All other items equal a percentage of the total assets.

For example, if SHM has total assets of $10,000 and debt of $3,000, then debt equals 30 percent (debt divided by total assets, or $3,000 divided by $10,000, which equals 30 percent).

· **To get a common size ratio from an income statement** (or profit and loss statement), you compare total sales.

· Total sales equal 100 percent. All other items equal a percentage of the total sales.

For example, if SHM has $50,000 in total sales and a net profit of $8,000, then you know that the profit equals 16 percent of total sales ($8,000 divided by $50,000, which equals 16 percent).

Keep in mind the following points with common size ratios:

· **Net profit:** What percentage of sales is it? What was it last year? How about the year before? What percentage of increases (or decreases) is the company experiencing?

· **Expenses:** Are total expenses in line with the previous year? Are any expenses going out of line?

· **Net equity:** Is this item higher or lower than the year before?

· **Debt:** Is this item higher or lower than the year before?

Common size ratios are used to compare the company’s financial data not only with prior balance sheets and income statements but also with other companies in the same industry. You want to make sure that the company is not only doing better historically but also as a competitor in the industry.

*Valuation Ratios*

Understanding the value of a stock is very important for stock investors. The quickest and most efficient way to judge the value of a company is to look at valuation ratios. The type of value that you deal with throughout this book is the *market value* (essentially the price of the company’s stock). You hope to buy it at one price and sell it later at a higher price — that’s the name of the game. But what’s the best way to determine whether what you’re paying for now is a bargain or is fair market value? How do you know whether your stock investment is undervalued or overvalued? The valuation ratios in the following sections can help you answer these questions. In fact, they’re the same ratios that value investors have used with great success for many years.

*Price-to-earnings ratio (P/E)*

The price-to-earnings ratio (P/E) can double as a profitability ratio because it’s a common barometer of value that many investors and analysts look at. I cover this topic in __Chapter 11__, but because it’s such a critical ratio, I also include it here. The formula is

P/E ratio = Price (per share) divided by Earnings (per share)

For example, if SHM’s stock price per share is $10 and the earnings per share are $1, the P/E ratio is 10 (10 divided by 1).

The P/E ratio answers the question, “Am I paying too much for the company’s earnings?” Value investors find this number to be very important. Here are some points to remember:

· Generally, the lower the P/E ratio, the better (from a financial strength point of view). Frequently, a low P/E ratio indicates that the stock is undervalued, especially if the company’s sales are growing and the industry is also growing. But you may occasionally encounter a situation where the stock price is falling faster than the company’s earnings, which would also generate a low P/E. And if the company has too much debt and the industry is struggling, then a low P/E may indicate that the company is in trouble. Use the P/E as part of your analysis along with other factors (such as debt, for instance) to get a more complete picture.

· A company with a P/E ratio significantly higher than its industry average is a red flag that its stock price is too high (or that it’s growing faster than its competitors). If the industry’s P/E ratio is typically in the range of 10–12 and you’re evaluating a stock whose P/E ratio is around 20, then you may want to consider avoiding it. A company’s P/E ratio not only needs to be taken in context with its industry peers but also based on its year-over-year performance.

· Don’t invest in a company with no P/E ratio (it has a stock price, but the company experienced losses). Such a stock may be good for a speculator’s portfolio but not for your retirement account.

· Any stock with a P/E ratio higher than 40 should be considered a speculation and not an investment. Frequently, a high P/E ratio indicates that the stock is overvalued.

When you buy a company, you’re really buying its power to make money. In essence, you’re buying its earnings. Paying for a stock that’s priced at 10 to 20 times earnings is a conservative strategy that has served investors well for nearly a century. Make sure that the company is priced fairly, and use the P/E ratio in conjunction with other measures of value (such as the ratios in this appendix).

*Price-to-sales ratio (PSR)*

The price-to-sales ratio (PSR) helps to answer the question, “Am I paying too much for the company’s stock based on the company’s sales?” This is a useful valuation ratio that I recommend using as a companion tool with the company’s P/E ratio (see the preceding section). You calculate it as follows:

PSR = Stock price (per share) divided by Total sales (per share)

This ratio can be quoted on a per-share basis or on an aggregate basis. For example, if a company’s market value (or market capitalization) is $1 billion and annual sales are also $1 billion, the PSR is 1. If the market value in this example is $2 billion and annual sales are $1 billion, then the PSR is 2. Or, if the share price is $76 and the total sales per share are $38, the PSR is 2 — you arrive at the same ratio whether you calculate on a per-share or aggregate basis. For investors trying to make sure that they’re not paying too much for the stock, the general rule is that the lower the PSR, the better. Stocks with a PSR of 2 or lower are considered very undervalued, but typically look for under 3 or 4.

Be very hesitant about buying a stock with a PSR greater than 5. If you buy a stock with a PSR of 5, you’re paying $5 for each dollar of sales — not exactly a bargain.

*Price-to-book ratio (PBR)*

No, this doesn’t have anything to do with beer, although I am enjoying a cold Pabst Blue Ribbon as I write this! The price-to-book ratio (PBR) compares a company’s market value to its accounting (or book) value. The book value refers to the company’s net equity (assets minus liabilities). The company’s market value is usually dictated by external factors such as supply and demand in the stock market. The book value is indicative of the company’s internal operations. Value investors see the PBR as another way of valuing the company to determine whether they’re paying too much for the stock. The formula is

Price-to-book ratio (PBR) = Market value divided by Book value

An alternative method is to calculate the ratio on a per-share basis, which yields the same ratio. If the company’s stock price is $20 and the book value (per share) is $15, then the PBR is 1.33. In other words, the company’s market value is 33 percent higher than its book value. Investors seeking an undervalued stock like to see the market value as close as possible to (or even better, below) the book value.

Keep in mind that the PBR may vary depending on the industry and other factors. Also, judging a company solely on book value may be misleading because many companies have assets that aren’t adequately reflected in the book value. Software companies are a good example. Intellectual properties, such as copyrights and trademarks, are very valuable yet aren’t fully covered in book value. Just bear in mind that, generally, the lower the market value is in relation to the book value, the better for you (especially if the company has strong earnings and the outlook for the industry is positive).