Business Ratios

Business ratios are a set of 22 different analytical formulas used to evaluate the overall value an performance of a business. In general, a sophisticated entrepreneur will utilize no less than a dozen of the business ratios to gain an overall understanding of the financial status of a company.

Value Investing – Business Ratios (Lesson 12)

Business ratios are used to compare similar companies within the same industry. RULE #1: DO NOT USE BUSINESS RATIOS TO COMPARE COMPANIES AGAINST EACH OTHER IF THEY ARE IN DIFFERENT INDUSTRIES.

Business ratios are not perfect, they have their respective flaws and it is important for value investors to understand the algorithms used with business ratios. It is also important to note that business ratios can be easily manipulated and result in misleading outcomes. More importantly, business ratios only reflect current information and not long-term trends. Think of business ratios as comparable to a doctor acquiring your vitals upon your medical visit. The vitals only reflect the ‘then and now’ status of your medical condition. They do not reflect your lifetime nor trending condition. 

In effect, business ratios have a purpose, although limited. They are the best tools to compare similar companies within the same industry and typically the same market capitalization tier. Thus, a second rule to use with rule number one above; RULE #2: USE BUSINESS RATIOS TO COMPARE SIMILAR MARKET CAPITALIZATION COMPANIES WITHIN THE SAME INDUSTRY.

Because business ratios can be easily manipulated, it is important that users of business ratios have a full understanding of their respective formulas. RULE #3: BUSINESS RATIOS ARE NOT AN ABSOLUTE RESULT. They are merely indicators and that is all they are good for when interpreting their results. 

Even with the above limitations, business ratios are beneficial to investors as they are the best method of comparing existing or potential investments. Their results are not perfect, but they can indeed provide adequate confidence when making pertinent decisions about a companies current financial status. 

Value Investing – Principle #3: Financial Analysis (Lesson 8)

Financial analysis is the basis to set up a predictable and reasonable market price for the respective stock. This becomes the sell price point or what is often referred to in this series of lessons as the recovery point. If all three forces (economic, industry and company level) are performing reasonably, then the stock price for the company will recover to this sell point within a short period of time. Therefore, it is important for value investors to understand the importance of having knowledge about financial analysis.

Financial analysis is an assessment of a company’s performance in the form of dollars. The goal is to establish a trend line of financial accomplishments. It is safe to assume that the historical results can predict future results with accuracy. Again, large corporations are money generating machines; it will take several adverse actions to slow down or diminish the ability to earn profits.

Financial analysis starts with gathering research data, specifically annual and the most recent quarterly financial reports. With this information, certain data is loaded into a spreadsheet so that ratios can be determined. With the spreadsheet data, trends are tracked and from there, summarized. This summary of pertinent outcomes assist the value investor with determining the most likely outcomes for the next several quarters. Take note, value investors are not as interested in extended time frames as this methodology is designed to determine an expected recovery value for the stock in the short-term. Value investors are not interested in holding to collect dividends, there are interested in the buy low, sell high tenet of business. Thus, long-term expectations are irrelevant.

Other key information is extracted from the quarterly and annual reports to confirm trends, validate business ratios and finally, determine the expected market recovery price.

Railroad Fund – Update 02/27/2020 Purchased Union Pacific

In yesterday’s post, I indicated that if Union Pacific’s share price drops to $156.79 that the fund would use its excess cash to purchase shares. Well, today at 10:35 AM it did drop to $156.39. Therefore, I used all remaining cash to purchase 8.268268 shares (includes $1 per share cost to make the purchase). If you read my article: Union Pacific – Buy/Sell Model you would understand that I use a 17% price change requirement to buy. With Union Pacific, this occurs about once every three years and it just did, driven by the market scare with coronavirus.

Return on Equity

Return on Equity

Another performance ratio used in business is return on equity. It is similar to return on assets except return on equity uses one section of the bottom half of the balance sheet.

Operating Profit Margin – Formula and Understanding

Operating Profit Margin - Formula and Understanding

Operating profit margin refers to the value earned as a percentage of net sales. The operating profit is often referred to as earnings before interest, taxes, depreciation and amortization, (EBITDA). This is a misleading reference as operating profit is actually defined differently by industry sector. EBITDA is used primarily in valuing businesses.

Total Assets Turnover Rate – Formula and Analysis

Total Assets Turnover Rate

Within the group of activity ratios, the total assets turnover rate is the broadest in scope. Similar to other activity ratios, it utilizes net sales as the numerator. However the denominator doesn’t focus in on a single balance sheet asset group like the working capital turnover or fixed assets turnover rates, it includes all assets.

Debt Ratio

Debt Ratio

Every business buys on account whether it is a traditional vendor account like that found in retail or simply using a credit card. A third party provides credit which creates debt for the business. The debt ratio reflects the percentage of assets covered by debt. 

Fixed Assets Turnover Rate

Fixed Assets Turnover Rate

The fixed assets turnover rate is another activity ratio whereby an income statement financial characteristic is compared to a balance sheet asset section. In this case, comparing adjusted sales against historical cost of fixed assets. This financial business ratio is only effective for business operations that are fixed asset intensive. With service based industries like carpet cleaning, professional firms and medical practices this particular ratio is impractical.

Cash Ratio

Cash Ratio

One of the liquidity ratios used in business is the cash ratio. It is a much more effective tool for small business than the traditional current or quick ratio. Although the cash ratio is more difficult to manipulate in small business, most entrepreneurs miscalculate the result