Study Guide Module 10:

Financial Mix Ratio Analysis

What Is Ratio Analysis?

Ratio analysis is a quantitative method of gaining insight into a company's liquidity,

operational efficiency, and profitability by studying its financial statements such as the
balance sheet and income statement. Ratio analysis is a cornerstone of fundamental
equity analysis.

A ratio is the relation between two amounts showing the number of times one value
contains or is contained within the other.

Types of Ratio Analysis

The various kinds of financial ratios available may be broadly grouped into the
following, based on the sets of data they provide:

1. Liquidity Ratios

Liquidity ratios measure a company's ability to pay off its short-term debts as they
become due, using the company's current or quick assets. Liquidity ratios include the
current ratio, quick ratio, and working capital ratio.

What Are Liquidity Ratios?

Liquidity ratios are a class of financial metrics used to determine a debtor's ability to
pay off current debt obligations without raising external capital. Liquidity ratios
measure a company's ability to pay debt obligations and its margin of safety through
the calculation of metrics including the current ratio, quick ratio, and operating cash
flow ratio.

Understanding Liquidity Ratios

Liquidity is the ability to convert assets into cash quickly and cheaply. Liquidity ratios
are most useful when they are used in comparative form. This analysis may be
internal or external.

For example, internal analysis regarding liquidity ratios involves using multiple
accounting periods that are reported using the same accounting methods. Comparing
previous periods to current operations allows analysts to track changes in the business.
In general, a higher liquidity ratio shows a company is more liquid and has better
coverage of outstanding debts.

Alternatively, external analysis involves comparing the liquidity ratios of one company
to another or an entire industry. This information is useful to compare the company's
strategic positioning to its competitors when establishing benchmark goals. Liquidity
ratio analysis may not be as effective when looking across industries as various
businesses require different financing structures. Liquidity ratio analysis is less effective
for comparing businesses of different sizes in different geographical locations.

Types of Liquidity Ratios

The Current Ratio

The current ratio measures a company's ability to pay off its current liabilities (payable
within one year) with its total current assets such as cash, accounts receivable, and
inventories. Calculations can be done by hand or using software such as Excel. The
higher the ratio, the better the company's liquidity position:

The Quick Ratio

The quick ratio measures a company's ability to meet its short-term obligations with its
most liquid assets and therefore excludes inventories from its current assets. It is also
known as the acid-test ratio:

2. Solvency Ratios

Also called financial leverage ratios, solvency ratios compare a company's debt levels
with its assets, equity, and earnings, to evaluate the likelihood of a company staying
afloat over the long haul, by paying off its long-term debt as well as the interest on its
debt. Examples of solvency ratios include: debt-equity ratios, debt-assets ratios, and
interest coverage ratios.

A solvency ratio is a key metric used to measure an enterprise’s ability to meet its
long-term debt obligations and is used often by prospective business lenders. A
solvency ratio indicates whether a company’s cash flow is sufficient to meet its long-
term liabilities and thus is a measure of its financial health. An unfavorable ratio can
indicate some likelihood that a company will default on its debt obligations.

Understanding Solvency Ratios

A solvency ratio is one of many metrics used to determine whether a company can
stay solvent in the long term. A solvency ratio is a comprehensive measure of
solvency, as it measures a firm's actual cash flow, rather than net income, by adding
back depreciation and other non-cash expenses to assess a company’s capacity to stay
afloat.

It measures this cash flow capacity versus all liabilities, rather than only short-term
debt. This way, a solvency ratio assesses a company's long-term health by evaluating
its repayment ability for its long-term debt and the interest on that debt.

Solvency ratios vary from industry to industry. A company’s solvency ratio should,
therefore, be compared with its competitors in the same industry rather than viewed in
isolation.

A solvency ratio terminology is also used when evaluating insurance companies,

comparing the size of their capital relative to the premiums written, and measures the
risk an insurer faces on claims it cannot cover.

Types of Solvency Ratios

A. Interest Coverage Ratio

The interest coverage ratio is calculated as follows:

where:

 EBIT = Earnings before interest and taxes

The interest coverage ratio measures how many times a company can cover its current
interest payments with its available earnings. In other words, it measures the margin
of safety a company has for paying interest on its debt during a given period.

The higher the ratio, the better. If the ratio falls to 1.5 or below, it may indicate that a
company will have difficulty meeting the interest on its debts.

B. Debt-to-Assets Ratio

The debt-to-assets ratio measures a company's total debt to its total assets. It
measures a company's leverage and indicates how much of the company is funded by
debt versus assets, and therefore, its ability to pay off its debt with its available assets.
A higher ratio, especially above 1.0, indicates that a company is significantly funded by
debt and may have difficulty meetings its obligations.

C. Equity Ratio

The shareholder equity ratio is calculated as follows:

The equity ratio, or equity-to-assets, shows how much of a company is funded

by equity as opposed to debt. The higher the number, the healthier a company is. The
lower the number, the more debt a company has on its books relative to equity.

D. Debt-to-Equity (D/E) Ratio

The debt-to-equity (D/E) ratio is calculated as follows:

The D/E ratio is similar to the debt-to-assets ratio, in that it indicates how a company
is funded, in this case, by debt. The higher the ratio, the more debt a company has on
its books, meaning the likelihood of default is higher. The ratio looks at how much of
the debt can be covered by equity if the company needed to liquidate.

3. Stability Ratios

Stability is the long-term counterpart of liquidity. Stability analysis investigates how

much debt can be supported by the company and whether debt and equity are
balanced. The most common stability ratios are the Debt-to-Equity ratio and gearing
(also called leverage).

 debt-to-equity ratio = (Net debt) / (Shareholders’ equity)

  gearing = (Net debt) / (Net debt + Shareholders’ equity)
 Net debt = Interest-bearing debt – Excess cash.

Net debt is defined as interest-bearing long-term and short-term debt less excess cash
in the business. Note that only interest-bearing net debt is included here, and other
current liabilities are excluded as they are short-term and can impact on liquidity, but
not stability. Excess cash is the cash held on the balance sheet that is not needed and
exceeds the normal cash level required for business operations (usually 3%-5% of
annual sales).

4. Profitability Ratios

These ratios convey how well a company can generate profits from its operations.
Profit margin, return on assets, return on equity, return on capital employed, and gross
margin ratios are all examples of profitability ratios.

What Are Profitability Ratios?

Profitability ratios are a class of financial metrics that are used to assess a business's
ability to generate earnings relative to its revenue, operating costs, balance sheet
assets, or shareholders' equity over time, using data from a specific point in time. They
are among the most popular metrics used in financial analysis.

Profitability ratios can be a window into the financial performance and health of a
business. Ratios are best used as comparison tools rather than as metrics in isolation.

Profitability ratios can be used along with efficiency ratios, which consider how well a
company uses its assets internally to generate income (as opposed to after-cost
profits).

Return ratios are metrics that compare returns received to investments made by
bondholders and shareholders. They reflect how well a business manages the
investments to produce value for investors.

Types of Profitability Ratios

Profitability ratios generally fall into two categories—margin ratios and return ratios.

Margin ratios give insight, from several different angles, into a company's ability to
turn sales into profit. Return ratios offer several different ways to examine how well a
company generates a return for its shareholders using the money they've invested.
Some common examples of the two types of profitability ratios are:

 Gross margin
 Operating margin
 Pretax margin
 Net profit margin
 Cash flow margin
 Return on assets (ROA)
 Return on equity (ROE)
 Return on invested capital (ROIC)
 Price to sales (P/S) ratio

Margin Ratios

Different profit margins are used to measure a company's profitability at various cost
levels of inquiry. These profit margins include gross margin, operating margin, pretax
margin, and net profit margin. The margins between profit and costs expand when
costs are low and shrink as layers of additional costs (e.g., cost of goods sold (COGS),
operating expenses, and taxes) are taken into consideration.

Gross Margin

Gross profit margin, also known as gross margin, is one of the most widely used
profitability ratios. Gross profit is the difference between sales revenue and the costs
related to the products sold, the aforementioned COGS. Gross margin compares gross
profit to revenue.

A company with a high gross margin compared to its peers likely has the ability to
charge a premium for its products. It may indicate the company has an important
competitive advantage. On the other hand, a pattern of declining gross margins may
point to increased competition.

Some industries experience seasonality in their operations. For example, retailers

typically experience significantly higher revenues and earnings during the year-end
holiday season. Thus, it would be most informative and useful to compare a retailer's
fourth-quarter profit margin with its (or its peers') fourth-quarter profit margin from
the previous year.

Operating Margin

Operating margin is the percentage of sales left after accounting for COGS as well as
normal operating expenses (e.g., sales and marketing, general expenses,
administrative expenses). It compares operating profit to revenue.
Operating margin can indicate how efficiently a company manages its operations. That
can provide insight into how well those in management keep costs down and maximize
profitability.

A company with a higher operating margin than its peers can be considered to have
more ability to handle its fixed costs and interest on obligations. It most likely can
charge less than its competitors. And it's better positioned to weather the effects of a
slowing economy.

Pretax Margin

The pretax margin shows a company's profitability after accounting for all expenses
including non-operating expenses (e.g., interest payments and inventory write-offs),
except taxes.

As with other margin ratios, pretax margin compares revenue to costs. It can signal
management's ability to run a business efficiently and effectively by boosting sales as it
lowers costs.

A company with a high pretax profit margin compared to its peers can be considered a
financially healthy company with the ability to price its products and/or services most
appropriately.

Net Profit Margin

The net profit margin, or net margin, reflects a company's ability to generate earnings
after all expenses and taxes are accounted for. It's obtained by dividing net income
into total revenue.

Net profit margin is seen as a bellwether of the overall financial well-being of a

business. It can indicate whether company management is generating enough profit
from its sales and keeping all costs under control.

Its drawback as a peer comparison tool is that, because it accounts for all expenses, it
may reflect one-time expenses or an asset sale that would increase profits for just that
period. Other companies won't have the same one-off transactions. That's why it's a
good idea to look at other ratios, such as gross margin and operating margin, along
with net profit margin.
Cash Flow Margin

The cash flow margin measures how well a company converts sales revenue to cash. It
reflects the relationship between cash flows from operating activities and sales.

Cash flow margin is a significant ratio for companies because cash is used to buy
assets and pay expenses. That makes the management of cash flow very important. A
greater cash flow margin indicates a greater amount of cash that can be used to pay,
for example, shareholder dividends, vendors, and debt payments, or to purchase
capital assets.

A company with negative cash flow is losing money despite the fact that it's producing
revenue from sales. That can mean that it might need to borrow funds to keep
operating.

A limited period of negative cash flow can result from cash being used to invest in,
e.g., a major project to support the growth of the company. One could expect that that
would have a beneficial effect on cash flow and cash flow margin in the long run.

Return Ratios

Return ratios provide information that can be used to evaluate how well a company
generates returns and creates wealth for its shareholders. These profitability ratios
compare investments in assets or equity to net income. Those measurements can
indicate a company's capability to manage these investments.

Return on Assets (ROA)

Profitability is assessed relative to costs and expenses. It's analyzed in comparison

to assets to see how effective a company is at deploying assets to generate sales and
profits. The use of the term "return" in the ROA measure customarily refers to net
profit or net income—the value of earnings from sales after all costs, expenses, and
taxes. ROA is net income divided by total assets.

The more assets that a company has amassed, the greater the sales and potential
profits the company may generate. As economies of scale help lower costs and
improve margins, returns may grow at a faster rate than assets, ultimately increasing
ROA.

Return on Equity (ROE)

ROE is a key ratio for shareholders as it measures a company's ability to earn a return
on its equity investments. ROE, calculated as net income divided by shareholders'
equity, may increase without additional equity investments. The ratio can rise due to
higher net income being generated from a larger asset base funded with debt.
A high ROE can be a sign to investors that a company may be an attractive
investment. It can indicate that a company has the ability to generate cash and not
have to rely on debt.

Return on Invested Capital (ROIC)

This return ratio reflects how well a company puts its capital from all sources (including
bondholders and shareholders) to work to generate a return for those investors. It's
considered a more advanced metric than ROE because it involves more than just
shareholder equity.

ROIC compares after-tax operating profit to total invested capital (again, from debt
and equity). It's used internally to assess appropriate use of capital. ROIC is also used
by investors for valuation purposes. ROIC that exceeds the company's weighted
average cost of capital (WACC) can indicate value creation and a company that can
trade at a premium.

What Are the Most Important Profitability Ratios?

The profitability ratios often considered most important for a business are gross
margin, operating margin, and net profit margin.

Why Are Profitability Ratios Significant?

They're significant because they can indicate the ability to make regular profits (after
accounting for costs), and how well a company manages investments for a return for
shareholders. They can reflect management's ability to achieve these two goals, as
well as the company's overall financial well-being.

How Is Business Profitability Best Measured?

The gross profit margin and net profit margin ratios are two commonly used
measurements of business profitability. Net profit margin reflects the amount of profit
a business gets from its total revenue after all expenses are accounted for. Gross profit
margin indicates profit that exceeds the cost of goods sold.

The Bottom Line

Profitability ratios offer companies, investors, and analysts a way to assess various
aspects of a company's financial health. There are two main types of profitability
ratios: margin ratios and return ratios.

Margin ratios measure a company's ability to generate income relative to costs. Return
ratios measure how well a company uses investments to generate returns—and wealth
—for the company and its shareholders.
5. Growth Ratios

Growth rates or ratio refer to the percentage change of a specific variable within a
specific time period. Growth rates can be positive or negative, depending on whether
the size of the variable is increasing or decreasing over time. Growth rates were first
used by biologists studying population sizes, but they have since been brought into use
in studying economic activity, corporate management, or investment returns.

For investors, growth rates typically represent the compounded annualized rate of
growth of an investment, or a company’s revenues, earnings, or dividends. Growth
rates are also applied to more macro concepts, such as gross domestic product
(GDP) and unemployment. Expected forward-looking or trailing growth rates are two
common kinds of growth rates used for analysis.

 Revenue Growth

 Revenue Growth is the increase, or decrease, in an organization’s sales between

two periods. Communicated as a percentage, revenue growth demonstrates the
degree to which organization's revenue has grown or shrunk over time. It's one
of the most common and important Startup metrics. The Revenue Growth Rate
provides a solid indicator of how quickly the organization is growing.
 Revenue Growth Rate = (Current Period Revenue - Prior Period
revenue) / Prior period revenue
 A double-digit percentage revenue growth is considered to be good.
  Margin Growth

 Margin Growth is the increase, or decrease, in an organization’s Net Margin

(Profit After Tax) between two periods. Communicated as a percentage,
MarginGrowth demonstrates the degree to which organization's margin has
grown or shrunk over time. Margin Growth rate is used by creditors, investors,
and businesses themselves as indicators of the organization's financial health,
management's skill, and future cash flow potential.
 Margin Growth Rate = (Current Period Margin - Prior Period Margin) /
Prior period Margin
 During the initial years of the operation, the Margin Growth may be disappointing
due to heavy expenses without compensating revenue. However, for such
organizations, the business plan for the next 5-10 years should also be
considered for the decision-making purpose.

 CAGR

Compound Annual Growth Rate (CAGR)

The compound annual growth rate (CAGR) is a variation on the growth rate that is
often used to assess an investment’s or company’s performance. The CAGR, which is
not a true return rate, but rather a representation that describes the rate at which an
investment would have grown if it had grown at the same rate every year and the
profits were reinvested at the end of each year. The formula for calculating CAGR is:

 The CAGR calculation assumes that growth is steady over a specified period of
time. CAGR is a widely used metric due to its simplicity and flexibility, and many
firms will use it to report and forecast earnings growth.
 CAGR eliminates the fluctuation of growth during the intermittent period and
provides a single average growth rate between two periods of time.
What Are Growth Rates?

Growth rates refer to the percentage change of a specific variable within a specific
time period. Growth rates can be positive or negative, depending on whether the size
of the variable is increasing or decreasing over time. Growth rates were first used by
biologists studying population sizes, but they have since been brought into use in
studying economic activity, corporate management, or investment returns.

For investors, growth rates typically represent the compounded annualized rate of
growth of an investment, or a company’s revenues, earnings, or dividends. Growth
rates are also applied to more macro concepts, such as gross domestic product
(GDP) and unemployment. Expected forward-looking or trailing growth rates are two
common kinds of growth rates used for analysis.

Understanding Growth Rates

At their most basic level, growth rates are used to express the annual change in a
variable as a percentage. For example, an economy’s growth rate is derived as the
annual rate of change at which a country’s GDP increases or decreases. This rate of
growth is used to measure an economy’s recession or expansion. If the income within
a country decline for two consecutive quarters, it is considered to be in a recession.

Using Growth Rates

Company and Investment Growth Rates

Growth rates are utilized by analysts, investors, and a company’s management to

assess a firm’s growth periodically and make predictions about future performance.
Most often, growth rates are calculated for a firm’s earnings, sales, or cash flows, but
investors also look at growth rates for other metrics, such as price-to-earnings ratios or
book value, among others. When public companies report quarterly earnings, the
headline figures are typically earnings and revenue, along with the growth rates—
quarter over quarter, or year over year—for each.

For example, Amazon reported full-year revenue of $232.89 billion for 2018; this
represented growth of 30.93% from 2017 revenue of $177.9 billion. Amazon also
reported that its earnings totaled $10.07 billion in 2018, compared to $3.03 billion in
2017, so the firm’s growth rate for earnings on a year-over-year basis was a whopping
232%.1

The internal growth rate (IGR) is a specific type of growth rate used to measure an
investments or project’s return or a company’s performance. It is the highest level of
growth achievable for a business without obtaining outside financing, and a firm’s
maximum IGR is the level of business operations that can continue to fund and grow
the company.
Investors often look to rate of return (RoR) calculations to compute the growth rate of
their portfolios or investments. While these generally follow the formulae for growth
rate or CAGR, investors may wish to also know their real or after-tax rate of return.
Thus, growth rates for investors will net out the impact of taxes, inflation, and
transaction costs or fees.

Because stock prices are thought to reflect the discounted value of a firm’s future cash
flows, a rising stock market implies improving forecasted growth rates for the
company.

Example of a Growth Rate

Say that we are comparing the annual growth rates of two countries’ GDP.

 Country A is a developed economy with a large, skilled population and a high

degree of technology. It had a GDP over three years of:

 year 1: $1.20 trillion

 year 2: $1.26 trillion (growth y1 to y2 = 6/120 = 5.0%)

 year 3: $1.29 trillion (growth y2 to y3 = 3/126 = 2.4%)

 Country B is a developing economy with a rapidly growing population of

unskilled but cheap labor and only a moderate degree of technology. Its GDP
over the same period was:

 year 1: $20 billion

 year 2: $25 billion (growth y1 to y2 = 50/200 = 25.0%)

 year 3: $35 billion (growth y2 to y3 = 100/250 = 40.0%)

How to Use Qualitative Factors in Fundamental Analysis

What Are Quantitative Factors?

The quantitative side involves looking at factors that can be measured numerically,
such as the company's assets, liabilities, cash flow, revenue, and price-to-earnings
ratio. The goal of fundamental analysis is to produce a quantitative value that investors
can compare with a security's current price, to help determine whether the security is
undervalued or overvalued.

The limitation of quantitative analysis, however, is that it does not capture the
company's aspects or risks unmeasurable by a number—things like the value of an
executive or the risks a company faces with legal issues. The analysis of these things is
the other side of fundamental analysis: the qualitative side or non-number side.

What Is Qualitative Analysis?

In business and management, qualitative analysis uses subjective judgment to analyze

a company's value or prospects based on non-quantifiable information, such as
management expertise, industry cycles, strength of research and development, and
labor relations.

Qualitative analysis contrasts with quantitative analysis, which focuses on numbers

found in reports such as balance sheets. The two techniques, however, will often be
used together to examine a company's operations and evaluate its potential as an
investment opportunity.

Understanding Qualitative Analysis

The distinction between qualitative and quantitative approaches is similar to the

difference between human and artificial intelligence. Quantitative analysis uses exact
inputs such as profit margins, debt ratios, earnings multiples, and the like. These can
be plugged into a computerized model to yield an exact result, such as the fair value of
a stock or a forecast for earnings growth. Of course, for the time being, a human has
to write the program that crunches these numbers, and that involves a fair degree of
subjective judgment. Once they are programmed, though, computers can perform
quantitative analysis in fractions of a second, while it might take even the most gifted
and highly-trained humans’ minutes or hours.

Qualitative analysis, on the other hand, deals with intangible, inexact concerns that
belong to the social and experiential realm rather than the mathematical one. This
approach depends on the kind of intelligence that machines (currently) lack, since
things like positive associations with a brand, management trustworthiness, customer
satisfaction, competitive advantage, and cultural shifts are difficult, arguably
impossible, to capture with numerical inputs.

How Qualitative Factors Impact Fundamentals

Although relatively more difficult to analyze, the qualitative factors are an important
part of a company. Since they are not measured by a number, they tend to be
subjective and represent either a negative or positive force affecting the company. But
some of these qualitative factors will have more of an effect than others, and
determining the extent of these effects can be challenging.

Examples of qualitative factors include customer satisfaction with a company's

products, pending litigation that harms a company's reputation, a change in a
company’s management, the relationship the company has with key vendors, or
ownership of a new technology that gives the company a competitive advantage.

How to Perform a Qualitative Analysis

To start, identify a set of qualitative factors and then decide which of these factors add
value to the company and which of these factors decrease value. Then determine their
relative importance. The qualities you analyze can be categorized as having a positive
effect, negative effect, or minimal effect.

If, when looking at the company's numbers, you saw good reason to buy the company,
but subsequently found many negative qualities, you may want to think twice about
buying. Negative qualities might include potential litigation, poor research and
development prospects, a reputation for poor customer service, or a board full
of insiders. The conclusions of your qualitative analysis either reconfirms or raises
questions about the findings from your quantitative analysis.

Example of Qualitative Analysis

In May 2017, Verizon Communications (VZ) beat out rival AT&T (T) in a bidding war to
purchase Straight Path Communications, Inc. for $3.1 billion.1 If you were to look at
just the quantitative factors regarding this acquisition, you might wonder why either
Verizon or AT&T would think Straight Path was such a coveted prize.

At the time, Straight Path's numbers didn't indicate it was a company worth billions of
dollars. Just a few months before the acquisition, the small communications company
had a market capitalization of around $400 million, had only nine employees, and was
selling for $36.48 a share.21 However, the company owned a hugely valuable asset—a
treasure trove of Federal Communications Commission (FCC) wireless licenses needed
to power 5G, the next generation of high-speed wireless service.

Both Verizon and AT&T knew that whichever company could control these licenses
would be a step ahead in building out their 5G business. So, they were willing to pay a
premium for Straight Path, causing the company's share price to skyrocket from
$36.48 to the eventual acquisition price of $184 per share.1 Investors who only looked
at Straight Path's financial statements to value the company in a quantitative analysis
might have missed out on what gave the company its competitive advantage and
made it qualitatively superior, which was its ownership of those highly prized FCC
licenses.

The Bottom Line

Fundamental analysis is not as simple as looking at numbers and computing ratios. It

is also important to look at influences and qualities that do not have a number value.

The best way to incorporate qualitative analysis into your evaluation of a company is to
do it once you have completed the quantitative analysis. The conclusions you come to
on the qualitative side can put your quantitative analysis into better perspective and
might help you make a better investment decision.