Financial Ratio Analysis - How to Read Financial Statements

Anybody who reads financial statements without a calculator in hand, or a spreadsheet open, is missing a trick. You don't need to build a huge financial model and forecast ten years into the future to get value out of it. But I think you do need at least two, preferably three or four years' reports, and a good dose of pragmatism. This isn't about working out the 'right' number in the way accounting students do, with multiple adjustments - it's more about getting a good feel for the trends.

Margins

First off, I never, ever read a results statement without calculating the operating margins and, if I'm looking at a retailer or reseller, the gross margins. If you have a revenue growth story with declining operating margins - forget it. (That kept me out of a number of bad tech stocks during the internet boom years.)

I then check my findings against the wordy bit of the report. For instance, China Shoto says in its interim statement that gross margins rose because the lead price - one of its main inputs - fell. However, the operating margin declined. Something's up there - which the company doesn't explain.

Operating margins are a key figure for comparing companies in the same sector (though adding back depreciation and amortisation gives a more useful result if the companies'  policies are very different). This can sometimes be useful not just for spotting recovery stocks, but for assessing their potential value. Suppose I find a company which is making just 3% return on sales, but its competitors are making 8-10% with the same business model. If management can get margins up to 8% within two years, then I can work out what that would be on flat sales (or sales slightly down, if they're aiming to cut out unprofitable lines of business), and estimate what earnings per share would be at that level of operating margin. Then just apply a PER to it and hey presto - I have my target value.

Profitability

I also look at a number of ratios that compare the balance sheet and the profit and loss account - relating profit to the capital the company uses to generate it. (These are figures that always seem to be missed out of even quite educated reporting, such as the Investors Chronicle.) You can use return on assets, return on capital employed, and so on. ROA has the advantage of cancelling out the advantages any company gains from gearing up, so it shows basic operational efficiency; on the other hand ROCE shows the efficiency with which the company is using its shareholders' funds,  and that obviously affects the actual return you're getting.

The importance of these figures is that they show you what returns the company is getting from investing in its business - and if that's less than inflation, or less than the interest rate you could get on the funds, then that should tip you off that it's a poor investment. In 1998, quite a few telecoms companies in Russia were making ROCE of 4%, while the interest rate was above 18% - that if nothing else should have told you the Russian economy wasn't a great investment (and it tumbled later that year).

You might not be surprised to hear that high and steady ROCE is one of the factors Warren Buffett looks for in making his investments. (You will, probably, be as surprised as I was to find out that emerging markets companies have a return on equity 40% higher than the MSCI World Index ^[1] - a fact which has made me rethink my stance on emerging markets.)

Efficiency

Some people also use the asset turnover ratio - basically how much in sales a company manages to make for each pound of assets. However, I've found it isn't really as useful as the profit-related figures, except in one special case. When a company is losing money in a profitable industry, the asset turnover ratio will tell you whether it's because the company is not selling enough product - or whether it's because it's selling lots of product but at a loss. The management action needed in each case is, of course, different - in the first case, a marketing drive is needed, and you need to ask how well the company can compete against its rivals (is its product dated or unattractive?) - in the second case, cost cutting is what's needed, or perhaps increased prices.

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Now operating margin and ROCE/ROA will tell you whether the company is doing well. But there are also a number of ratios you ought to look at to see the stress factors that can pull a company down. The working capital ratios are the leaders here. For instance you'd naturally want to know how many days' inventories the company has money tied up in - a build up of stocks can indicate slower sales, and if the stock becomes obsolete, the company's got a real problem.

The same goes for receivables. One of the best bits of investment advice I was ever given came from a friend who worked in IT consulting. “If a company has more than 60 days' receivables,” he said, “forget it. Thirty days to invoice, thirty days to pay, that's sixty, and if they have any more, they're going to have problems getting that money out of their customers.” That doesn't work in all sectors - in construction, for instance, stage payments for major projects are normal, and that may mean receivables days are extended - but if the ratios are lengthening continually, that's a sure sign of financial stress.

Leverage

Finally, just take a quick look at the balance sheet and work out the net debt (or cash) and gearing. A lot of companies say 'we have £xm cash in our balance sheet' and conveniently don't mention that they also have bank borrowings. I'm not interested in gross cash, particularly as no business can run its operations without some cash in hand - and businesses that take deposits (eg travel agents), have large amounts of cash that don't really belong to them. It's the net cash, or net debt, that I care about, and that isn't shown on the balance sheet - you have to work it out.

I have to stress that this is not rocket science. It is all fairly simple stuff. Getting the ratios just requires a little application and a bit of time. I should also stress that the ratios will not tell you whether a company is a good investment or a bad one. They will simply show you that, let's say, it is less profitable than another company in the same sector. Up to you to find out why. (Bad management? A low cost, bottom end of the market operator? Strategy to increase market share at the short-term expense of profits?)

But doing the ratios properly does show you the questions you should be asking. And it's also a way of evaluating management and checking that what they are saying in the discussion of operations doesn't put a spin on the truth, or distract you from underlying problems.

Oh yes. One last thing you need to do with a spreadsheet before you're finished - and this one has got me out of three or four stocks six months ahead of a really bad result. Just check the half-year on half-year comparisons. Because we don't have quarterly reporting, most people just look at the full year results against last year's. However, it can often be surprising what happens when you calculate the second half and look at the progression of revenue and profit growth for each six month period. A company that's apparently growing quite nicely year-on-year at the interims may actually be a long way behind its second half performance last year - and you can bet it's not all seasonality.