Financial Ratio Analysis
The basis for fundamental analysis
At the heart of fundamental analysis are the financial ratios which allow the stock investor to evaluate a company's financial performance based on data taken from the financial statements.
The basic financial ratios such as the earnings per share growth rate, price earnings ratio, price earnings growth rate and the dividend yield provide the beginner investor with an introduction to basic idea behind financial ratio analysis. These ratios form the basis for analyzing a company's earnings and are based on the company's income statement.
There are some additional ratios that deal with the company's revenue and earnings which provide a more complete analysis of a company's ability to generate a profit. These additional earnings ratios are broadly grouped into Revenue based ratios and Earnings based ratios.
For the stock investor to fully benefit from fundamental analysis they need to perform a more through analysis which deals with the company's balance sheet and these ratios can be broadly group into Asset based ratios.
While analyzing the revenue and earnings of a company provides valuable information regarding its profitability, information taken from the balance sheet provides valuable information on a company's ability to maintain its profitability.
The main purpose of using fundamental ratios is that they allow the stock investor to quickly determine the current financial status of a company. This allows the stock investor to determine whether a proposed investment is an investment in a company which is fundamentally sound or not and whether it's a bankruptcy risk.
The analysis reports in the Stock Reports section gives investors practical experience using fundamental analysis on actual companies with instructional guidance.
Generally the information contained in the financial statements is readily available in a summarized form and the fundamental ratios are often already calculated. To truly benefit from the use of fundamental ratios it is beneficial to understand how these financial ratios are calculated.
The information is available in a summarized form
with the fundamental ratios already calculated
Some stock investors feel that analyzing a company's financial position using fundamental ratios is something best left to accountants. While it is true that accountants produce the financial statements, websites such as Yahoo Finance extract the information provided in these financial statements and provide them in a summarized format along with the fundamental ratios already calculated. This summarized information is explicitly intended for stock investors so that they can make an informed investment decision regarding that company.
Accountants are only interested in producing the financial statements; they are not interested in using the information for investment decision making purposes.
The stock investor can perform a more thorough financial analysis by incorporating financial ratios from prior years. This puts the current year's financial ratios into perspective and highlights any financial trends in the ratios which might be developing.
Stock investors like to avoid companies where the bankruptcy risk is high and the Z-score is a popular indicator based on ratios which gives the likelihood of a company going into bankruptcy with two years.
Once the stock investor has analyzed the trends in the financial ratios, the company can then be compared to its competitors within the same industry. This is achieved by conducting an industry based ratio analysis which puts the company's financial position into perspective.
Revenue Based Ratios
Earnings are important, but don't overlook revenue
Revenue Growth Rate
A lot of stock investors emphasize the company's earnings without regard to the revenue (also known as sales) which generated those earnings. The company's revenue is even more important to analyze than the earnings since any problems with the generation of revenue will ultimately be reflected in the company's earnings.
In order for a company to growth, its revenue needs to consistently increase over the years. The revenue growth is what increases its fundamental valuation and thus increases its stock price. The revenue growth rate allows the stock investor to monitor the increase in revenue over the years.
The revenue growth rate is calculated by subtracting the prior year revenue from the current years revenue. This figure is then divided by the prior year's revenue and multiplied by 100 so that the result is expressed as a percentage. The revenue growth rate can also be used with next years forecast revenue.
Example 1. A company with a current year's revenue of $30,000,000, last year's revenue of $28,000,000 and a forecast revenue of $35,000,000 gives
Current Revenue Growth Rate = (30,000,000-28,000,000) / 28,000,000*100 = 8%
Forecast Revenue Growth Rate = (35,000,000-30,000,000) / 30,000,000*100 = 17%
The stock investor should always be aware of any mergers or acquisitions since these will increase revenue but the increase is not due to the company's normal operations.
The revenue growth rate works best if the stock investor keeps a record of the past revenue growth rates. This allows any changes in the year to year revenue growth rate to be identified.
A more detailed analysis of the revenue increase can be obtained from the income statement. The cause of the revenue increase might be purely due to inflation or it might be due to an increase in the quantity sold. The latter is the preferred method of increasing revenue as this indicates the company is growing. Another consideration is whether the industry overall is growing. A concern is when the company grows its revenue at a significantly slower rate than that of the industry and is probably a sign that the competition is taking their market share.
The Gross Margin ratio measures the effect of the direct costs involved in generating the company's revenue.
The gross margin is calculated by dividing the gross profit by the revenue and multiplied by 100 so that the result is expressed as a percentage. The gross profit is obtained from the income statement and is simply the revenue with the direct costs deducted (do not confuse the gross profit with the net profit as there are expenses and taxes not yet deducted).
Example 2. A company with an current years revenue of $30,000,000 and direct costs of $20,000,000 gives
Gross Profit = 30,000,000-20,000,000 = $10,000,000
Gross Margin = 10,000,000/ 30,000,000*100 = 33%
The gross margin should remain fairly constant over the years. An increasing gross margin is generally not sustainable in the long-term due to competition. It is difficult for a company to increase its revenue without incurring a proportional increase in its direct costs. A company which has a monopoly on its industry (which is what the famous investor - Warren Buffett looks for) can force lower direct costs from its suppliers, but in the long-term competition will ultimately affect its ability to control its industry.
Falling gross margin is a sign that the company may be facing strong competition from its competitors and is reducing its prices to remain competitive. The net effect is that its revenue may still be increasing but its direct costs are increasing at a faster rate and this shows up with the gross margin declining over the years. The gross margin can also fall if the direct costs increase without a corresponding increase in revenue (due to discounting its sales prices).
The efficiency of which a company generates its profit is easily determined with the Net Margin ratio.
The Net Margin (also called the Profit Margin) is calculated by dividing the current years net profit by the current years revenue and multiplied by 100 so that the result is expressed as a percentage.
Example 3. A company with an current years revenue of $30,000,000 and current years Net Profit of $2,500,000 gives
Net Margin = 2,500,000 / 30,000,000*100 = 8%
The net margin should remain fairly consistent over the years. An increasing net margin is generally not sustainable due to the economics of business competition.
Falling net margin is a sign that the company may be running into financial difficulties or at the very least the company is facing strong competition from its competitors and is reducing its prices to remain competitive. The net effect is the same as that with the gross margin.
Price Earnings Based Ratios
Earnings - the investors favorite financial measure
Earnings Growth rate
The Earnings Growth rate is the companion to the Revenue Growth rate and allows the stock investor to monitor the increase in earnings as well as revenue. The earnings growth rate can use either net profit (earnings) or earnings per share data. When using earnings per share data this ratio is usually known as the EPS growth rate.
The earnings growth rate is calculated by subtracting the prior year's earnings from the current years earnings. This figure is then divided by the prior year's earnings and multiplied by 100 so that the result is expressed as a percentage. The earnings growth rate can also be used with next years forecast Earnings.
Example 1. A company with an current years Earnings of $3,000,000, last years Earnings of $2,800,000 and a forecast Earnings of $3,500,000 gives
Current Earnings Growth ratio = (3,000,000-2,800,000) / 2,800,000*100 = 8%
Forecast Earnings Growth ratio = (3,500,000-3,000,000) / 3,000,000*100 = 17%
The stock investor should always be aware of any mergers or acquisitions since these will increase earnings but the increase is not due to the company's normal operations.
The earnings growth rate works best if the stock investor keeps a record of the past earnings growth rates together with the revenue growth rates. Any changes in the year to year earnings growth rate can be identified and compared to the revenue growth rates. A consistent earnings growth rate in line with an increasing revenue growth rate indicates that the company is growing.
The PE ratio stands for Price Earnings ratio and is the most commonly cited ratio by the financial press. While it is a useful ratio it needs to be used with caution.
The PE ratio is calculated by dividing the current stock price by the earnings per share (EPS).
Example 2. A company with an annual EPS of $5 and a stock price of $80 gives
PE ratio = 80 / 5 = 16
There are a couple of issues with the PE ratio that the stock investor needs to be aware of.
The first one is that the PE ratio is meaningless when the company makes a loss since the value becomes negative.
Secondly, the PE ratio represents what the market is currently paying for the latest reported earnings and it is not an indication of what the company is actually worth.
Thirdly, the stock investor needs to be aware of an earnings result that is abnormally different from previous years. If the earnings are abnormally high compared to previous years then the current PE ratio will be exceptionally low lulling investors into a false sense of security that the stock is now cheap.
Changes in the PE ratio should always be compared to both the earnings growth rates and the Revenue Growth rates.
The PEG ratio stands for Price Earnings Growth ratio.
The PEG ratio is calculated by dividing the PE ratio by the earnings growth rate. The PEG ratio can also be used with current data or forecast data.
Example 3. A company with an current PE ratio of 16 and a current EPS growth rate of 10% gives
Current PEG ratio = 16 / 10 = 1.6
Example 4. A company with an forecast PE ratio of 18 and a forecast EPS growth rate of 20% gives
Forecast PEG ratio = 18 / 20 = 0.9
The PEG ratio is commonly used to determine a stock's relative valuation. It is generally accepted that a stock is undervalued if its PEG ratio is less than one and that it is overvalued if more than one.
This general valuation technique can be used with both current and forecast PEG ratios. The current PEG indicates what the market is currently paying for the company's earnings performance. The forecast PEG indicates what the market is currently paying for the company's expected future earnings performance.
Diluted PE ratio
The Diluted PE ratio takes into account the effects of stockholder dilution of earnings which occurs when a company can increase the number of shares outstanding due to the existence of company issued options or convertible bonds.
The diluted PE ratio is merely the PE ratio but uses diluted earnings rather than reported earnings and is calculated by dividing the current stock price by the diluted EPS.
Example 5. A company with an annual diluted EPS of $4.50 and a stock price of $80 gives
Diluted PE ratio = 80 / 4.50 = 18
The diluted PE ratio is a conservative figure since usually not all company issued options are exercised and not all convertible bonds converted to stock. While most companies have company issued options not all companies have convertible bonds. Using diluted earnings for the PE ratio makes sense when comparing a company with a large quantity of convertible bonds or options to a company with little or none.
Dividend Payout ratio
The Dividend Payout ratio is a measure of the amount of dividends that a company pays out of the net profit it made.
The payout ratio varies significantly between companies. As a general rule, companies that are growing tend to payout very little if any dividends as they use the retained earnings to finance further expansion. Mature stable or very large companies tend to payout higher portions of the net profit as dividends.
The dividend payout ratio can be calculated in three ways. The first is to determine the total dividends paid, the second is to only include the dividends paid on common stock and the third is to only include the dividends paid on preferred stock.
The total dividend payout ratio is calculated by dividing the dividends paid on both common and preferred stock and dividing this buy the net profit. The result is then multiplied by 100 so that the result is expressed as a percentage.
Example 6. A company with an annual Net Profit of $3,000,000 pays out a total of $1,000,000 in dividends
Total Dividend Payout ratio = 1,000,000 / 3,000,000*100 = 33%
The common stock dividend payout ratio is calculated by dividing the dividends paid only to common stock and dividing this buy the net profit with the dividends paid to preferred stock subtracted from the net profit. The result is then multiplied by 100 so that the result is expressed as a percentage.
The preferred stock dividend payout ratio is calculated by dividing the dividends paid only to preferred stock and dividing this buy the net profit with the dividends paid to common stock subtracted from the net profit. The result is then multiplied by 100 so that the result is expressed as a percentage.
The common and preferred stock calculations are only applicable if the company has issued preferred stock.
Example 7. A company with an annual Net Profit of $3,000,000 pays out $400,000 in dividends to common stock and pays out $600,000 to preferred stock
Common stock Dividend Payout ratio = 400,000 / (3,000,000-600,000)*100 = 17%
Preferred stock Dividend Payout ratio = 600,000 / (3,000,000-400,000)*100 = 25%
It is normal for a company to payout more of its profits to preferred stock.
The return from a stock investment is comprised of two sources. The first is the capital gain from the stock and the second is the dividends received (if any).
Some stock investors are specifically after the dividend payments and the dividend yield provides the stock investor with an indication of what the dividend represents from their investment returns.
The dividend yield can be used with either common stock dividends or preferred stock dividends and is calculated buy dividing the current stock price by the current yearly dividends. The result is then multiplied by 100 so that the result is expressed as a percentage.
Example 8. A company with an annual Dividend payment of $2 and a stock price of $80 gives
Dividend yield = 2 / 80 * 100 = 2.5%
The dividend yield can also be calculated with forecast dividend data. For stock investors who own the stock they can use their purchase price and calculate the current dividend yield based on their original invested capital.
Asset Based Ratios
Investors often overlook the company's assets
The Current ratio (also known as the working capital ratio) is a commonly used fundamental measure which checks a company's working capital by comparing the current assets to the current liabilities. The current assets and liabilities are taken from the balance sheet statement. The working capital is the difference between the current assets and the current liabilities. The working capital is an absolute value but for analysis purposes a ratio reveals more information.
The current ratio is calculated by dividing the current assets by the current liabilities.
Example 1. A company with current assets of $30,000,000 and current liabilities of $13,000,000 gives
Current ratio = 30,000,000 / 13,000,000 = 2.3
Companies with a current ratio less than 2.0 are generally less favored by stock investors as the company begins to rely more heavily on short-term finance. Companies with less short-term debt tend to be less likely to run into financial problems further down the track as they have cash available now and in the immediate future to finance their operations.
Quick Assets ratio
Companies with high inventory levels do not show up with the current ratio. The Quick Assets ratio takes inventory levels into account by excluding them from the current assets. The quick assets ratio is not applicable to companies that do not carry any inventories.
The quick assets ratio is calculated by subtracting the Inventory levels from the current assets and then dividing this by the current liabilities.
Example 2. A company with Current Assets of $30,000,000, Inventory levels of $10,000,000 and Current Liabilities of $13,000,000 gives
Quick Assets ratio = (30,000,000-10,000,000) / 13,000,000 = 1.5
The generally accepted minimum value for the Quick Assets ratio is 1.0
Stock investors generally prefer companies with a quick assets ratio above 1.0 since high inventory levels tie up the cash flow which can lead to financial problems later on.
Debt Asset ratio
The Debt Asset ratio shows how much debt the company is carrying. It is a common ratio used by stock investors who track the debt level over time to reveal any trends.
The debt equity ratio is calculated by dividing the total Liabilities by the tangible total assets. The tangible total assets is the total assets with the intangible assets deducted. The debt asset ratio is also used in the form of debt equity which uses net assets instead of total assets.
Example 3. A company with total Liabilities of $40,000,000, intangible assets of $2,000,000 and total Assets of $100,000,000 gives
Debt Assets ratio = 40,000,000 / (100,000,000-2,000,000) x 100% = 41%
The debt assets ratio is especially useful when tracked over time. Stock investors generally do not like high debt levels since the company can more easily be placed under financial distress, especially if revenue levels drop.
An increasing debt level is highly undesirable if earnings growth is flat or even worse if they are falling. Stock investors will only consider an increasing debt level acceptable if it leads to an increase in the earnings growth rate. In other words, the company is financing its growth.
The Inventory Turnover shows how well the inventory costs are managed and a quarterly measure will highlight any seasonal variations.
The inventory turnover is calculated by dividing the cost of sales by the inventory cost.
Example 4. A company with cost of sales of $30,000,000 and an inventory cost of $8,000,000 gives
Inventory Turnover = 30,000,000 / 8,000,000 = 3.8
Stock investors prefer higher Inventory Turnover levels since the inventory is being used and not tied up with working capital. An extremely high Inventory turnover is however not desirable since the inventory levels may not be sufficient to keep pace with revenue and result in back orders.
Working Capital Turnover
The Working Capital Turnover is useful ratio as working capital is essential to a company's ability to generate its revenue.
The working capital turnover is calculated by dividing the revenue by the working capital. The working capital is calculated by subtracting the current liabilities from the current assets.
Example 5. A company with Revenue of $100,000,000 and Current Assets of $35,000,000 and Current Liabilities of $15,000,000 gives
Working Capital = 35,000,000 - 15,000,000 = 20,000,000
Working Capital Turnover = 100,000,000 / 20,000,000 = 5.0
The working capital turnover can be tracked over time and a declining trend is not desirable as it indicates that the amount of working capital required to produce the revenue is increasing. An increase in working capital means the company requires more cash flow and this trend increases the risk that the company will run into financial difficulties further down the track.
Return on Equity
The Return on Equity is a ratio which measures the amount of profit made by the company against the net assets owned by the stockholders.
The return on equity is calculated by dividing the net profit by the average stockholder equity and multiplied by 100 so that the result is expressed as a percentage.
The average stockholder equity is normally used in this ratio rather than the stockholder equity at the end of the fiscal year. The average stockholder equity is calculated by averaging the stockholder equity at the beginning of the year and the stockholder equity at the end of the year. The reason the average is normally used is that the stockholder equity may change during the year and using an average reflects that the earnings were generated over the year.
Example 6. A company with Net Profit of $10,000,000 and year end stockholder equity of $100,000,000 and year beginning stockholder equity of $95,000,000 gives
Average stockholder equity = (100,000,000 - 95,000,000) / 2 = 97,500,000
Return on Equity = 10,000,000 / 97,500,000 = 10.3%
Ideally stock investors would like to see the return on equity increase over the years as this indicates that the company can increase the amount of profit generated for the assets used.
Low returns on equity are not attractive to stock investors and companies with declining returns on equity are undesirable. The renowned Warren Buffett - who is probably the world's most famous investor - specifically looks for companies with high Returns on Equity.
Trends in the Financial Data
Look for trends in the data over a number of years
The simplest form of fundamental analysis using the financial ratios involves analyzing the data obtained from the current financial statements. While the current data provides valuable information about a company's financial position, the information is however rather limited and often is not conclusive.
The maximum benefit from financial ratios analysis is achieved when the financial ratios from past years are incorporated into the analysis which allows any trends to emerge. It is these trends which highlight when something is fundamentally changing with the company. Generally around five years of financial ratio history is sufficient, but sometimes needs to be increased to ten years.
The financial ratios tend to vary somewhat from year to year and having several years of data allows the stock investor to put the current financial ratio values into perspective. For example, the current value of a particular financial ratio might be lower than the previous year, however when checking past years it may become evident that the values tend to fluctuate from year to year but the general trend is that the value increases over the years.
Any of the common financial ratios can be analyzed for its trending nature. The revenue growth rate and the earnings growth rate should always be analyzed with prior years growth rates so that the current growth rate is put into perspective. Only analyzing the growth rate from the current year will often mask the true long-term growth prospects of the company.
The Net Margin is another financial ratio that should be tracked over the years for its trend. A declining Net Margin is readily detected when viewing data from prior years. Stock investors who are looking for dividend payments should track the trending nature of the Dividend Payout ratio.
It is also beneficial to track the balance sheet ratios such as the Current ratio and the Debt Assets ratio for their trending nature. A continuously declining Current ratio is undesirable even if it is above 1.0 since the working capital is declining year after year. An increasing debt level is readily observed when tracking the Debt Assets ratio over a number of years.
The financial ratios being tracked can be placed into a table which allows the stock investor to easily analyze the data for its trending nature.
An example is shown below in Table 1. using hypothetical values.
Table 1. Financial ratios over
a 5 year period
Sometimes an average of the prior years is more appropriate rather than using the current value of a financial ratio. For example, when the growth rates of revenue and earnings are generally steady, but tend to fluctuate around, rather than using the current growth rate it is more appropriate to use an average growth rate. However, if the growth rate tends to be generally increasing over the years then using an average is not appropriate.
The growth rate shown in Table 1. over the five year period tends to be fairly consistent so it would be appropriate to use an average value. Generally the earnings growth trend is following that of the Sales growth and this is supported by the fairly consistent Net Margins. Also the Current ratios and the Debt Equity ratios are fairly consistent and are not showing any increasing or declining trends. Therefore it is appropriate to use averages for all of these financial ratios.
Plotting the financial ratios on a graph provides the stock investor with a visual perspective of the trend which sometimes is not obvious when viewing the data in a tabular format. The data in a table might suggest that an average should be used since the data fluctuates, however when the data is plotted on a graph it starts to become obvious that these fluctuating values are indeed trending which might be upwards or downwards.
Table 2. below shows an example of a stock with fluctuating revenue and earnings growth rates.
Table 2. Financial ratios fluctuating
over a 5 year period
While the growth rates in Table 2. above can be averaged, it is a good idea to plot a graph and visually inspect the plotted data for any trending behavior that might be present.
The graph below shows the tabular data from Table 2. plotted.
Graph 1. Financial ratios trending up
over a 5 year period
Merely averaging the growth rates in Table 2. masks the fact that the growth rates are actually broadly increasing over the years. The graph clearly shows that the general trend is upwards, meaning that the revenue and earnings growth rates are actually increasing. Granted the 2015 growth rates declined by 1%, but the general trend is for the growth rates to increase and the 2016 growth rate may well be around 18 to 20%.
The use of historical financial ratios allows the stock investor to conduct a more through analysis compared to only using the current year's financial ratios. The stock investor may even come to a different conclusion about a stock once the historical data is included into their fundamental analysis.
The Fundamentally Sound Company
These companies make for a safer investment
A fundamentally sound company is a safer investment than a company which is under financial strain. A lot of investing strategies specifically seek out companies which are financially strong as these provide a cushion should stock prices fall.
A company which is in financially poor condition has no cushion should the stock price fall and they have a higher probability of winding up in bankruptcy meaning their stock is essentially worthless. There are however speculative strategies which specially seek out companies which are under financial strain, but these are not the subject of this article.
The risks associated with stock investing strategies such as growth investing and value investing are reduced when investing in fundamentally sound companies.
There are five characteristics that a fundamentally sound company exhibits.
The first characteristic is that the company generates revenue from selling a product or providing a service. A company that is not generating revenue does not receive any incoming cash from its operation. To financially survive the company will need to receive a cash flow from an external source.
The test is to check the company's recent revenue over the last five years or more. If only three years is available this may suffice, but five years provides a better long-term view (this also applies to the following tests as well). A company with relatively stable or increasing revenue is desirable. If the revenue is declining year after year then this is a concern.
2. Net Profit
The second characteristic is that the company makes a net profit fairly consistently. A company which is not regularly making a profit is probably using up its short-term cash flow and depleting its working capital. Most fundamentally sound companies can handle a net profit loss every so often, but if these losing years become more frequent it causes financial problems.
The test is to check the company's recent Net Profit figures over the last five years. A generally increasing Net Profit is desirable. If the Net Profit is declining year after year then this is a concern
The growth rates for revenue and net profit are not important for determining a company's financial soundness, but they are important to determine whether it's a growth stock.
3. Net Margin
The third characteristic is that the Net Margin remains fairly consistent over the five year period.
A quick test is to only check the current year for the company's Net Margin. Checking the Net Margin over a five year period provides a more reliable analysis. The Net Margin can be averaged and a higher value indicates that more profit is made for the same revenue. The typical Net Margin of companies varies significantly with different industries and tends to range from 5% to 20%.
An increasing Net Margin may at first seen attractive to stock investors, but companies have a tendency for their Net Margins to revert to their average which results from business competition. A Net Margin which is declining year after year is not desirable.
4. Working capital
The Forth characteristic is the company's working capital position. A lot of stock investors feel more comfortable if the company's Current Assets are at lest twice their Current Liabilities.
This is somewhat arbitrary and many fundamentally sound companies satisfactorily run their operations with working capital ratios that are less than 2.
A quick test is to only check the company's Current ratio for the current year (in order to check if the Current Assets are greater than Current Liabilities). This is not really a satisfactory test and the stock investor should check the Current ratio over the last five years to see if there is a declining trend. Any company with a declining Current ratio should be viewed skeptically.
5. Debt level
The fifth characteristic is that the long-term debt is not excessive. This is measured with the Debt Assets ratio
Checking the Debt Assets ratio for the current year will show the level of the company's long-term debt. While there is no accepted maximum, companies with Debt levels above 70% are carrying a lot of debt which means their interest payments are quite high.
It is prudent to check the Debt level over the last five years to see if there are any trends. A company which is consistently increasing its debt level without a corresponding increase in net profits is not desirable.
The Fundamentally Sound Company
The typical characteristics of a fundamentally sound company are shown below in Table 1.with five years of data.
Table 1. Characteristics of a fundamentally
From Table 1. above, the revenue is generally increasing even though the current year is slightly less than the previous year. This is quite normal and few companies will endure a never ending stream of sale increases every year. Most companies have competitors who are striving for a higher market share. The first test is satisfied.
The Net Profit is also generally increasing even though the increase fluctuates somewhat. Again, not too many companies will increase their net profits every single year and most companies will record a small loss every so often. The general trend here is up and this satisfies the second test.
Even the best companies will record
a losing year every so often
The Net Margin is satisfactory with an average of 7.5% and is fairly consistent from year to year. While the Net Margin is relatively low, this is fairly typical of companies which operate in industries which are capital equipment heavy such as the manufacturing industry. The Net Margin satisfies the third test.
The Current ratio measures the company's working capital position. The Current ratio is more than 2 which indicates the company has sufficient working capital. The Current ratio is fairly consistent from year to year and this satisfies the forth test.
The Debt Assets ratio shows the companies long-term debt level. The debt level of around 30% is very respectable and is consistent from year to year. This satisfies the fifth test.
Since all five tests were satisfied, this company is considered to be fundamentally sound.
A Company with Financial Problems
The typical characteristics of a Company with Financial Problems are shown below in Table 2. with five years of data.
Table 2. Characteristics of a Company
with Financial Problems
From Table 2. above, the revenue is generally flat year after year. This indicates that the company is either receiving increased competition or that the industry it belongs to is struggling. A quick check of the revenue figures from its competitors will reveal the source. While the revenue is not increasing, the company still has revenue which is fairly consistent and this satisfies the first test.
The Net Profit is positive on all five years but it is not increasing which is due to its revenue not increasing. The Net Profit is however fairly consistent and this satisfies the second test.
The Net Margin is also fairly consistent over the years but is quite low with an average of 3.2%. Even though the Net Margin is low, it is consistent and does not show a declining trend. This satisfies the third test.
The Current ratio shows a declining trend and is heading towards 1.0. This company is running out of its working capital and this is going to cause financial problems in the near future as the company will no longer have sufficient cash to finance its operations. This company fails the forth test.
The Debt Assets ratio is very high which in itself is not a major problem; however the Debt level is increasing year after year without any corresponding increase in net profit. This company also fails the fifth test.
This company failed the last two tests and is therefore not considered to be fundamentally sound.
If five years of data is not providing a conclusive opinion due to a volatile revenue and earnings history then ten years of data may be more appropriate to analyze.
Having performed these checks with five years of data should normally give the stock investor a pretty good idea of the financial position of the company. If the company passes all of the above five tests then the company is in all probability fundamentally sound. This however does not guarantee that the company will not run into financial difficulties in near future, but the odds of this occurring are low. It should be noted that just because a company is considered fundamentally sound it does not necessarily mean it is a good investment.
There are additional checks which can be made if required. A probability indicator such as the Z-score measures the likelihood of a company heading into bankruptcy within two years. This provides a useful supplementary analysis but it is based on probability. The indicator is only a guide and there is no guarantee that a company will not go bankrupt in the future even if the indicator suggests a low probability.
The above tests provide the stock investor with a guide to quickly determine the fundamental soundness of a company. While these tests may exclude some companies which are in reasonably good financial shape, the tests do exclude those stocks which are not financially sound.
Industry Based Ratio Analysis
Look beyond the financials of the individual company
Performing a financial ratio based analysis on an individual company provides the stock investor with valuable insight into that company's financial position. The only downside with this isolated approach is that the company operates their business in an industry environment which means they have competitors who are constantly trying to increase their revenue at the expense of the company.
Just like performing a ratio based analysis on only the current years financial data limits the effectiveness of the analysis, only performing a multiyear ratio based analysis on the company without regard to its operating environment also limits the effectiveness of the analysis.
The financial position of a company is relative and not absolute. This means that the company's true financial performance cannot be determined on its own but is in part dependant on the economic industry in which it operates. For example, a company with a Net Margin of 10% on its own says nothing about whether this is good or bad even if it has been steady for the last five years. In a capital intensive industry such as manufacturing this is probably a good result, but in a service oriented industry a 10% Net Margin might be a poor result. Similarly with the Current ratio, some industries naturally allow companies to operate with relatively high ratios while with other industries the working capital is limited.
To perform a complete fundamentally analysis the stock investor needs to put the company's financial position into perspective which means comparing it to its competition. This is the next step in the fundamental analysis process.
The industry a company belongs to can be analyzed in several ways.
Direct Competitors of Similar Size
The first analysis is to compare the financial performance of the company with similar sized companies in the industry. In other words, compare the financial ratios with that of its direct competition. This will highlight the relative financial performance.
A hypothetical example of comparing the relative financial performance of companies that are of similar size and in direct competition to each other is shown below in Table 1.
Table 1. Comparing companies in direct competition with each other
From Table 1. above, assuming that the stock investor was originally analyzing Company A which was determined to be fundamentally sound, a comparison with similar sized competitors puts this company into perspective. Comparing the average growth rates for revenue and earnings reveals that Company A is actually a financial under performer as the growth rates for Company C is twice that of Company A. Even Company B is performing slightly better than Company A.
No doubly Company C either has a superior marketing campaign or a superior product as its revenue growth rate is superior to the other two companies.
Also the Net Margin of Company C is nearly twice that of Company A which is to be expected due to its superior revenue and earnings growth rates.
Thus by comparing the financial performance of a company with its direct competitors highlights its relative performance.
The Industry Leader
The next form of industry analysis is to compare the company with the industry leader. The industry leader is the dominant company which is usually a large company and has the major market share of revenue for that industry. Sometimes there are several large dominant companies within an industry. Note: For the purpose of fundamental analysis, the industry leader is based on company revenue and not the relative strength where the stock price outperforms the industry index.
If the company being analyzed is the industry leader and there are no other dominant companies, then this analysis is not applicable. If there are other dominant companies in the industry, then the analysis is the same as that above which compares the company with its direct competitors which are of similar size.
When analyzing companies which are smaller than the industry leader, then it is prudent for the stock investor to compare their company's financial performance to that of the industry leader.
The industry leader provides a benchmark for comparison. Since the industry leader essentially controls the market, if the industry leader cannot increase its revenue then this makes it extremely difficult for a smaller company to increase its revenue. It is even worse if the industry leader's revenue are declining year after year as this indicates that industry overall is struggling and may be due to a weak economic environment.
Even if the revenue growth is reasonable, the dominant company may be operating on low profit margins which might be representative of that industry. In other words, revenue might be good but it just costs a lot of money to obtain that revenue. This is especially the case when there is a lot of aggressive competition, as they typically lower their prices in an attempt to increase their market share. The end result is that the Net Margins may drop to extremely low levels.
Thus even if a small company shows promise as an investment, any strong financial performance that the company currently exhibits may well be short lived.
There are always exceptions. If the industry is dominated by one single large company whose revenue is declining and/or is operating on low profit margins, then the stock investor can conduct a more thorough analysis of the industries smaller companies as it is possible that a smaller company is gaining revenue market share at the expense of the dominant company.
As history shows, today's leader may well be replaced with an up and coming company in the future who takes over as the new dominant company in that industry. Indeed many stock investors specifically seek out the small company that has the potential to become tomorrow's dominant company.
Industry Group Analysis
This form of industry analysis essentially combines the above and uses an average for the entire industry rather than the individual comparisons of the companies. Thus the performance of the smaller companies is average with the performance of the industry leaders which provides an overview of the entire industry.
The easiest way to get an overview is to simply average all of the financial ratios from each company in the industry group; however this approach can produce distorted and misleading figures and should generally not be used. For example, the revenue growth rate of the dominant company is 15% which has an 80% market share, if this is averaged with the growth rates of all the smaller companies in the industry group which have lower growth rates of only 5%, this will lead to an average growth rate closer to 5%. This is incorrect since the dominant company has most of the market share; an average growth rate closer to 15% is more representative of the market.
A more realistic and accurate analysis is to total up the revenue figures from all of the companies within that industry. These totals are calculated for each of the last five years or more if needed. The industry growth rate can then be calculated as the percentage change in Industry revenue from one year to the next.
The same method used to obtain the industry average for revenue can be applied to any of the other financial ratios such as Earnings growth rate and Net Margin or even Current Assets and Debt levels.
Incorporating an industry based analysis into the stock investor's fundamental analysis provides a complete financial picture of that company and its position within the industry it belongs to. Any competition the company may face which could hinder its future financial growth can be readily identified. This allows the stock investor to make an informed decision regarding a proposed investment in that company.
Knowing how a company's financial position compares to that of its peers simplifies the investing decision making process. The stock investor might be searching for tomorrow's leader and incorporating industry based analysis increases the likelihood of finding one.