Ratio Analysis

COMMONLY USED RATIOS

I. LIQUIDITY

Liquidity is defined as having enough cash (or near-cash assets) to pay your bills when they come due. The liquidity ratios compare the assets that will be converted into cash soon (the numerator) to the bills that will be coming due soon (the denominator).

You always want to compare the liquidity ratios to the industry average, but two other factors should be considered as well: The predictability (or stability) of the company’s sales. If you know how much money will be

received each month, you don’t need to keep as much cash on hand as you would otherwise. Companies with highly unpredictable sales are always in danger of experiencing a sudden shortfall in sales, so they need to keep more cash and liquid assets on hand.

The company’s access to bank lines of credit or the credit markets. You don’t need to keep as much money on hand if you can just pick up the phone, call the bank, and have money deposited into your account.

1. Current Ratio -- The current ratio is the most commonly used measure of the liquidity of a company. It is simply a common sense measure. The numerator is the value of assets that should be converted into cash within the next year. The denominator is the amount of bills coming due within the next year.

Current Ratio = Current AssetsCurrent Liabilities

2. Quick Ratio (or Acid Test Ratio) -- The quick ratio is a more restrictive measure than the current ratio. The numerator consists of the most liquid current assets. It assumes a worst-case scenario in which inventory cannot be sold.

The average for all manufacturing companies is about one (1.0). This average also varies a great deal from one industry to another.

Quick Ratio = Cash + Mkt . Securities + Acc. ReceivableCurrent Liabilities

A commonly used variation of the ratio is:

Quick Ratio = Current Assets - InventoryCurrent Liabilities

This is the version that you usually see in a standard finance textbook. But notice that this variation may include some non-liquid assets in the numerator however, such as prepaid expenses (like insurance premiums). This is the measurement that is actually used in practice most frequently, although the first form is theoretically superior.

II. TURNOVER (or EFFICIENCY)

Turnover ratios measure the management’s efficiency and effectiveness in managing the firm’s assets. In general, sales (or a measure of sales, like cost of goods sold) will be in the numerator. You would like for the value of the turnover ratios to be quite high (with the exception of the average collection period).

3. Inventory Turnover -- Indicates the number of times a year that the firm’s inventory has been replaced. A low ratio may indicate that the firm has some obsolete inventory, or that possibly, the firm is simply overstocked on inventory. If the inventory turnover is 4 times per year, the company is replacing its inventory approximately every 3 months; if its inventory turnover is 12 times per year, it is replacing its inventory approximately every 30 days (or 1 month).

The most commonly used form of the ratio is:

A theoretically-superior variation of the formula is:

Inventory Turnover = Cost of Goods SoldAverage of last 4 quarters' Inventory

This form of the ratio is better for two reasons: Why substitute “Cost of Goods Sold” for “Sales” in the numerator? Inventory (in the

denominator) is shown on the company’s books at cost; we would like to use a measure of cost in the numerator as well (i.e., cost of goods sold) in order to get a fairer comparison.

Why substitute “Average Inventory” for “Inventory” in the denominator? The numerator is measured over a period of time, like a year. The denominator should show the average amount of inventory that was available for sale during this period. For example, assume that sales increased rapidly during the year and that inventory increased dramatically as well. We would not want to use year-ending inventory in the denominator, as it does not accurately depict the amount of inventory that was available for sale.

4. Accounts Receivable Turnover -- Indicates how quickly the company collects its accounts receivable: the higher the turnover, the more quickly it collects its receivables.

Notice that the formula assumes that all sales are on credit (and therefore go through accounts receivable). It would be better to use credit sales in the numerator, if the value of credit sales is available. But, if you compare the ratio to an industry average, just make sure that you are using the same formula as your source for the industry average. You don’t want to use credit sales in the numerator if the industry average is calculated with total sales in the numerator.

5. Average Collection Period – Technically, this is not a turnover ratio: it is the accounts receivable turnover divided into 365 days. It is an alternate measure of how quickly accounts receivable are being collected. The ratio calculates how long (in days) that it takes the firm to collect its receivables. (Use credit sales if available, since only credit sales go through the accounts receivable account.)

If the A/R turnover is lower than the industry average (and the average collection period is higher than the industry average), this just means that the company is collecting its receivables slower than other firms in the industry. However, it is quite possible that the company’s credit terms may give its customers longer to pay than its competitors. So, rather than the industry average, it is better to compare the company’s average collection period to the terms that they sell on, if the credit terms are known.

6. Total Asset Turnover -- The purpose of investing in assets is to generate sales: the higher the sales per dollar invested in total assets, the better. This ratio measures how efficiently the management is achieving its goal.

Major fault of the ratio: Total assets are made up of current assets and fixed assets. If the company’s fixed assets are old (and therefore almost fully depreciated), the value of net fixed assets on the balance sheet will be quite small. This, in turn, will make total assets appear to be small and the value of the ratio will be high. This implies that a company with old assets is managing its assets quite efficiently. In fact, the company may not be managing its assets well at all – they are simply old and very depreciated. A company that has recently upgraded its assets by investing in newer equipment may actually be better managed, but its total asset turnover ratio will look inferior to the company with older assets. In spite of this, the total asset turnover ratio is widely used; it’s simply important to know of its major deficiency when using it.

III. DEBT (OR LEVERAGE)

The debt, or leverage, ratios measure the ability of the firm to meet the principal and interest payments on its debt. Keep in mind that debt is neither good nor bad; it is simply a tool. There are times that heavy use of it is appropriate (e.g., when sales are going up) and there are times that it is detrimental (when sales are going down). These ratios simply measure the extent to which the company is using debt in financing the company’s assets and whether it has gone too far by using so much debt that it is having difficulty in paying the interest when it is due.

7. Debt Ratio -- Indicates the percentage of the total assets that have been financed by debt.

Debt Ratio = Total Debt (or Liabilities )

Total Assets

On the balance sheet, total assets must equal total liabilities and capital. In other words, total assets are equal to the amount of the company’s debt plus the amount of equity. Looked at another way,

the company is financed with a combination of debt and equity. So this ratio simply measures the percentage of the total assets that are financed with debt. If the debt ratio is 40%, this means that the company has financed 40% of its assets with debt (borrowed money) and 60% with equity (investors’ money). This ratio is one way of measuring the financial leverage of the company: the higher the debt ratio, the higher the degree of financial leverage that the company has.

8. Debt-to-Equity -- A variation of the debt ratio. Measures the money invested by creditors relative to the money invested by the owners.

Debt-to-Equity Ratio = Total Debt (or Liabilities )

Total EquityThis is just another way of measuring the degree of financial leverage. Notice that if the debt ratio is 40%, this means that every $1.00 of total assets is financed with $0.40 in debt and $0.60 in equity. If we knew that the debt ratio is 40%, could we figure out the value of the debt-to-equity ratio? Sure, because we know that if debt is 40% of the assets, then equity must be the other 60%. Therefore, the debt-to-equity ratio is a ratio of 40/60, or 66.67%. Some financial analysts prefer to use the debt ratio; others prefer to use the debt-to-equity ratio. It isn’t necessary to use both of them because they tell you the same information - just in a different form.

9. Times Interest Earned (or Interest Coverage) - A key measure of the firm’s ability to meet its interest payments on time.

Times Interest Earned (or Interest Coverage ) = Net Operating Income (or E. B . I .T .)

Interest Expense

Notice that the numerator is the amount of earnings that is available to meet interest payments. The denominator shows the amount of those interest payments. In other words, it is a ratio of the amount of money that we have to the amount of money that we need (to pay the interest). So a high ratio would indicate an ability to pay its interest without difficulty.

IV. PROFITABILITY

Since a major goal of the company is to attain a high level of profitability, we would like to see a high value for these ratios. We can relate the company’s profits to almost any item on the balance sheet or income statement (e.g., net income to total assets, net income to common equity, net income to sales, etc.)

10. Return on Assets – The primary purpose of investing in assets is to generate sales, which in turn lead to profits. The return on assets ratio measures the profitability per dollar of investment in the firm. Notice that the ratio doesn’t say anything about how the assets are financed, i.e., where the money comes from (either debt or equity). It simply wants to know how profitable the company is per dollar invested in total assets (no matter where the money comes from to finance those assets).

Return on Assets = Earnings After TaxesTotal Assets

Note: You will see a lot of variations in the numerator for this ratio: some analysts use earnings before taxes (EBT), others will use earnings before interest and taxes (EBIT). The most common, however, is earnings after taxes (EAT). Just make sure that, if you are comparing a company’s

return on assets ratio to an industry average, you are calculating the ratio in the same manner as your source for the industry average.

11. Return on Equity – This ratio looks at the company’s profits from the standpoint of the company’s owners. It measures the profitability per dollar of investment in the firm by the owners.

Note: As with the previous ratio, you will see a lot of variations in the numerator for this ratio. Again, just make sure that, if you are comparing a company’s return on equity ratio to an industry average, you are calculating the ratio in the same manner as your source for the industry average.

12. Price-Earnings Ratio -- The price-earnings ratio is the most frequently used measure of a stock’s relative value. The price-earnings ratio tells us two things about a company’s stock: It is a measure of how optimistic investors are about the company’s future growth in earnings

and dividends. The higher the P/E ratio, the more optimistic investors are about the company’s future prospects.

It is a measure of the premium that you have to pay for the stock. For example, if a stock’s P/E ratio is 35 and the average P/E for all stocks is 18, investors are having to pay a considerable premium to acquire the stock (but may be getting a higher quality company). On the other hand, if a stock’s P/E ratio is 8, we are able to buy the stock at a discount relative to other stocks (but may be getting an inferior company).

Price-Earnings Ratio = Current market price of the common stockEarnings per share (for the past 12 months )

The P/E ratio is often used to help estimate the future price of the stock using this equation:Pricen = [P/E ratio]n times [Earnings per share]n

where “n” refers to a specific year in the future.For example, the price of a stock 3 years from now will be equal to the P/E ratio that the stock has 3 years from now times the earnings (per share) that the stock has 3 years from now. That is,

Price3 = [ P/E Ratio ]3 * [ Earnings per share ]3Price3 = 12 * $3 . 00 = $36 .00

If we can estimate the value of the P/E ratio 3 years from now and the earnings expected at that time, we can use the equation to estimate the market price of the stock at that time.

ADDITIONAL RATIOS THAT YOU MAY ENCOUNTER

V. VALUATION

Valuation ratios help determine whether a stock is over-priced or under-priced relative to other stocks (or relative to the basic earning power of the company). In general, we would like to purchase the items in the denominators (earnings, cash flow, sales, etc.) for a low price. Therefore, we prefer to invest in companies that have a low value for the following ratios.

13. Price-to-Cash Flow Ratio – The ultimate objective to investing is to earn a relatively high cash flow. If we can purchase this high cash flow at a cheap price, so much the better. Therefore, we would like to have invest in companies that have a low price-to-cash flow ratio.

Price- to - Cash Flow Ratio = Current market price of the common stockCash flow per share

14. Price-to-Sales Ratio – This ratio helps to value a company that has no earnings and no dividends. Also, the price-to-sales ratio may be more stable than the price/earnings ratio and, therefore, more useful. Research also supports the idea that a portfolio of stocks that have a low price-to-sales ratio may be an anomaly and outperform portfolios made up of high price-to-sales ratios.

Price- to - Sales Ratio = Current market price of the common stockSales per share (i . e . , [Total Sales ]/ [shares outstanding ]

15. Price-to-Book Value Ratio – This ratio relates the common stock’s market value to its “accounting value” as shown on the company’s books. One major respected research study maintains that stocks with a low price-to-book value ratio tend to outperform other portfolios.

Price- to - Book Ratio = Current market price of the common stockCommon equity as shown on the balance sheet

VI. MORE EFFICIENCY RATIOS

16. Capital Spending-to-Depreciation – This ratio assumes that the depreciation charges are an accurate reflection of the physical wear-and-tear on the fixed assets, i.e., the rate at which the fixed assets are being used up. Capital spending is the amount of money that is spent on the purchase of new fixed assets. So a ratio of capital spending-to-depreciation would show whether the fixed assets are being replaced at the same rate that they wear out. In other words, a ratio value greater than 1.0 would indicate that the assets are being adequately replaced; a value of less than 1.0 would indicate a shrinkage in the size of the fixed assets.

Capital Spending-to-Depreciation = Capital SpendingDepreciation

VII. MORE DEBT (OR LEVERAGE) RATIOS

17. EBITDA-to-Debt Service – EBITDA (pronounced ee-bit-DAH) can be determined by adding interest expense, taxes, and depreciation/amortization to earnings after taxes (i.e., EAT or net income). EBITDA is therefore the amount of money that is available to meet any payment obligations (i.e., interest and principal payments) on the company’s debt. (Debt service refers to these interest and principal payments.)

Therefore, the ratio relates the amount of money that we have from this year’s cash flow that is available to pay down the debt (and related interest) to the amount of required payments. A ratio of 1.0 would be the bare minimum that would be required to meet these payments. However, you would want a much larger cushion than this to ensure that the cash flow will not drop to levels that are not sufficient to meet the debt payments.

EBITDA-to-Debt Service = EAT + Interest expense + Taxes + Depreciation + AmortizationRequired interest payments + Required principal payments on the debt

VIII. MORE PROFITABILITY RATIOS

18. Gross Profit Margin (or Gross Margin) – By definition, gross profit is equal to total sales minus cost of goods sold. Therefore, if the gross profit margin declines, it is an indication that one of two things is likely happening: The cost of goods sold are increasing, and the company is not able to pass along the higher

costs in the form of price increases (possibly due to a highly competitive marketplace), or The company has reduced its prices, perhaps in an attempt to attract new customers and to

increase its market share.

Gross Profit Margin = Gross ProfitTotal Sales

19. Net Profit Margin (or Net Margin) – Whereas the gross profit margin measures the performance of the company’s operating managers, it doesn’t say anything about the performance of the company’s financial managers. (Gross margin is affected only by the decisions of operating managers with regard to pricing and cost control; it isn’t affected by decisions on how to finance the company.) The net profit margin measures the combined performance of both the operating and financial managers.

Net Profit Margin = Earnings After TaxesTotal Sales

20. Return on Investment – Return on investment could be stated as the return on “long-term investment funds”. Investment here refers to the total long-term sources of funds to a company, i.e., long-term liabilities, preferred stock, and common equity. The current liabilities are a temporary source of financing and may vary considerably over the course of a year; the providers of long-term funds have made a commitment to the company and provide the permanent financing for the firm.

Return on Investment = Earnings After TaxesLong-term Liabilites + Preferred Stock + Common Equity

A Comparison of Ratios

The table below contains some recent ratios of three companies in the restaurant industry. (Sources: Reuters and Microsoft Investor) The first few lines of the table show the company name, the ticker symbol, the headquarters' city, and the brand names owned by the company. The ratios were compiled in early 2012 and are used here to illustrate the larger subject of financial statement analysis.

Ratio Analysis of Selected Restaurant Companies

Brinker International (EAT), Dallas, TX, Chili's, Maggianos, On The Border, Macaroni Grill YUM! Brands (YUM), Louisville, KY, Pizza Hut, KFC, Taco Bell, LJS (Long John Silver), A&W Darden Restaurants (DRI), Orlando, FL, Olive Garden, Red Lobster, Longhorn Steakhouse, Bahama Breeze, seven Seas Liquidity Brinker Intl. YUM! Brands Darden Rest. Industry SectorCurrent Ratio 0.49 1.01 0.42 1.14 1.37 Quick Ratio 0.37 0.39 0.19 1.00 1.13

Debt (Leverage) Total Debt to Equity 1.74 1.55 1.20 0.66 0.93Interest Coverage 6.99 14.03 7.38 2.92 0.39

Turnover (Activity) Receivable Turnover 32.80 39.71 124.00 191.05 15.73 Inventory Turnover 21.07 41.85 15.65 30.79 16.47 Asset Turnover 1.31 1.46 1.40 1.60 0.79

Profitability Return on Assets (%) 9.92 17.21 8.16 8.34 5.05 Return on Equity (%) 36.45 77.10 25.02 15.87 11.15

Valuation Ratios Brinker Intl. YUM! Brands Darden Rest. Industry Sector0P/E Ratio 18.12 22.56 14.75 80.49 15.56Beta 1.47 0.94 0.89 0.35 0.96

As we examine these ratios, we need to keep in mind that, although all three companies are in the restaurant industry, YUM Brands (for the most part) is a fast-food company while the other two are "sit down" restaurants.

A review of the ratios reveals the following about the companies:

Profitability Ratios

Profitability Brinker Intl. YUM! Brands Darden Rest. Industry SectorReturn on Assets (%) 9.92 17.21 8.16 8.34 5.05 Return on Equity (%) 36.45 77.10 25.02 15.87 11.15

As a potential investor, we may want to emphasize the Return on Equity (ROE) ratio a little more than the Return on Assets (ROA). The return on equity tells us how much the company is earning per dollar invested by the shareholders.

1. Current results: YUM! Brands is currently the most profitable of the three companies (by both ratios that measure profits). All three are have an ROE greater than the industry average. But these three companies are among the largest in the industry and, when we compare to the industry average, we are comparing them to much smaller companies. Since restaurant chains have considerable fixed operating expenses (i.e., operating leverage), we would expect the larger chains to be more profitable than smaller ones. But, in order of ROE, YUM is the most profitable, Brinker is second, and Darden is third.

Next, let's take a look at where these profits come from. In other words, are the company's profits coming from sound management or are the ROE numbers being pushed up through the heavy use of financial leverage (i.e., debt)?

Debt (or Leverage) Ratios

Debt (Leverage) Brinker Intl. YUM! Brands Darden Rest. Industry SectorTotal Debt to Equity 1.74 1.55 1.20 0.66 0.93Interest Coverage 6.99 14.03 7.38 2.92 0.39

Brinker uses more debt (per dollar of equity) than either of the other two companies. This is an indication that Brinker is pushing up its ROE through its use of debt more so than YUM or Darden. In comparing YUM and Brinker, this makes YUM's ROE a little more impressive since YUM has a higher ROE and a lower debt level. Brinker has been able to push its ROE up above Darden's by magnifying its profits though the use of greater financial leverage. But higher debt also means higher risk. The important question here is, "Have the companies taken on more debt that they can repay?"

1. The Total Debt to Equity ratio values for all three companies are well above the industry average. This is normally a red flag and an analyst should ask this question, "The average firm in the industry believes that it can only support a debt level that is half the level of these two companies. What makes me believe that these two can support such a high debt load?" All three companies are benefiting from the higher debt levels, but what about their ability to pay the principal and interest on this debt? For this, we need to look at the Interest Coverage ratio for all three companies..

2. Interest Coverage: The Interest Coverage ratio measures the ability of the company to pay the principal and interest on the debt. All three companies have ratios greater than the industry average. (Some analysts use a rough rule-of-thumb that a minimum value of 3.0 is needed to safely support the debt level.) While all three companies appear to be safe in terms of being financially able to pay off its debt, YUM has the highest ratio value and therefore appears to be the safest of the three by this measure.

So far, it appears that YUM may be the strongest of the three firms financially. It has the highest level of profitability, is using its financial leverage appropriately to push up earnings, and can safely meet its debt obligations. We now turn to the other ratios to see if they raise any red flags for the companies.

Liquidity Ratios

Liquidity Brinker Intl. YUM! Brands Darden Rest. Industry SectorCurrent Ratio 0.49 1.01 0.42 1.14 1.37 Quick Ratio 0.37 0.39 0.19 1.00 1.13

All three companies have lower ratios than the industry average. This is not surprising, however, since this can be explained by two factors:

1. Stability of sales and cash flows: Being industry leaders, their sales and cash flows are more stable than the smaller firms in the industry, thus they don't need as much cash on hand. The purpose of liquidity is to make sure that you have enough money to pay your bills when they come due and to handle sudden changes in fortunes. If you can predict your cash flows pretty accurately, you don't need to keep as much cash on hand. And its easier to predict cash flows accurately if you have the stability and maturity as a result of being an industry leader.

2. Access to credit lines: Being large companies, these three have easy access to the credit markets. Most companies of this size will have lines of credit, so they have been pre-approved for any loans. There is no need to keep large amounts of cash on hand if you can pick up the phone and have the bank transfer money into your bank account when it is needed. (Technically, you would be "drawing down" the loan that was previously approved.)

Turnover (or Activity) Ratios

Turnover (Activity) Brinker Intl. YUM! Brands Darden Rest. Industry SectorReceivable Turnover 32.80 39.71 124.00 191.05 15.73 Inventory Turnover 21.07 41.85 15.65 30.79 16.47 Asset Turnover 1.31 1.46 1.40 1.60 0.79

1. Receivables Turnover is much higher than the industry average for all three companies, so there are no apparent problems with collecting accounts receivable. But this ratio can be a "trap" for analysts who aren't careful in studying the ratios. The restaurant industry is largely a "cash" industry anyway with low amounts of credit granted to its customers. So the receivables turnover ratio may not be meaningful for this industry. Just as the inventory turnover ratio

doesn't mean much for a service industry like hotels, airlines, and accounting firms, the receivables turnover ratio doesn't mean much for a cash-oriented business. So we will tend to "throw out" this ratio for the restaurant industry and not give it much importance.

2. Inventory Turnover varies widely among the three companies, with YUM enjoying an advantage over the other two. This shouldn't be surprising since YUM is in the fast-food segment of the restaurant and the other two are "sit down" restaurant companies.

3. The Asset Turnover ratios of all three firms are below the industry average. Again, we have to be careful with this ratio since we don't know how many of the restaurants are franchised (and, therefore, its stores or fixed assets owned by the local franchisees) and how many of the stores are company-owned (and therefore on the companies' books).

Valuation Ratios

Valuation Ratios Brinker Intl. YUM! Brands Darden Rest. Industry SectorP/E Ratio 18.12 22.56 14.75 80.49 15.56Beta 1.47 0.94 0.89 0.35 0.96

1. P/E Ratio: As measured by the Price/Earnings Ratio, investors are slightly more optimistic about YUM! Brands' future growth than Brinker or Darden. The higher P/E ratio also means that, as investors, we have to pay a higher premium to buy YUM. This premium means that, to buy one dollar of earnings, we have to pay approximately 50% more for YUM than for Darden and 25% more for YUM than for Brinker.

2. Beta: Beta measures the volatility of the stock price (with 1.0 being the average for all companies). Brinker International's stock is approximately 50% more volatile than its two competitors, which makes it a riskier investment. Darden has the lowest beta with YUM being a close second.

Summary

So what does our ratio analysis of the three companies tell us?

1. Brinker International - At the time of the review, Brinker had an impressive level of profitability (ROE) although its heavy use of debt to push up these earnings should be noted. The company is the riskiest of the three in terms of both interest coverage and its stock's value of beta.

2. YUM! Brands - At the time of the review, YUM had the strongest financial position. It had the highest level of profitability, a very strong ability to support its debt, and a low volatility for its stock price. Unfortunately for potential investors, the company also has the highest premium that must be paid for its stock. Is it worth a 50% premium in price? Each individual investor would have to make that decision.

3. Darden Restaurants - At the time of the review, Darden had the lowest (but more than industry-average) level of profitability, a strong ability to meet its debt service payments, and a low volatility of its stock price.

Caveat: This financial statement analysis is for educational purposes only; it should not be used as a reason to buy or sell any of the three stocks.

Breakdown of Return on Equity (ROE)(DuPont Method of Analysis)

Glossary

Return on Equity - A ratio that measures the profitability of the company. It is calculated by dividing a company's Earnings After Taxes (EAT or net income) by the company's common equity.

DuPont Method - A method of analysis that breaks down return on equity into the sources of that profitability. The method is named for the company that originally conducted the analysis.

The Sources of A Company's Profits

It is possible to break down the return on equity (ROE) ratio into several smaller parts. This is useful because there are five ways, and only five ways, for a company to increase its profits. Four of these ways are captured in the following equation:

Margin x Turnover x Leverage x Tax effect = ROE

E.B.T.Sales x Sales

Total Assets x Total AssetsCom. Equity x 1 - tax rate = ROE

This breakdown shows the sources of a company's profits. A company can:

1. improve its profit margin by doing a better job of controlling costs and pricing its products appropriately,

2. increase its turnover through the use of effective advertising, branding, sales promotions, and training of employees,

3. increase its leverage by utilizing debt at an appropriate level, and 4. reduce the amount of taxes paid as a result of effective tax planning (although this is

generally the least important of the four factors).

(There is a fifth source of a company's profits - cheaper leverage - but the movement of interest rates in the economy is not under the control of any individual company. Therefore the four sources shown above are the areas that a company’s management can control.)

If we take a closer look that the above equation, we can see that two of the four factors (margin and turnover) are controlled by the operating managers and that two (leverage and tax effect) are controlled by the financial managers. For this reason, the first two factors are often referred to as operating factors and the last two are referred to as financial factors.

Why Is This Important?

Why is this important? It's simply because most investors would rather see a company's profits originate from the operating factors rather than the financial factors. In other words, which would you rather invest in? A company that is

performing very well in the operations area (purchasing, production, shipping, etc.), maintains effective cost controls, and prices its products well, but has a low level of debt (i.e., is financed primarily with equity)

or a company that is:

performing very poorly in the operations area and is very aggressively financed (i.e., has a high level of debt)? The high debt level takes a small operating profit and multiplies it several times.

Most of us would rather invest in the first of the two choices. After all, increasing a company's leverage generally increases its risk. So our choice is: (1) to invest in a company that managed very well and which has low risk in its financing, or (2) to invest in a company that is managed very poorly and which has high risk in its financial policy. The choice is obvious.

All of this is important because a company's managers will often attempt to pump up a weak operational profit by adding large amounts of leverage to the company. In other words, a weak operating result is enhanced through the use of high amounts of leverage. If we simply calculate a company’s ROE and stop there, we may be easily misled unless we examine the source of that company's profits.

Consider This Example

For example, consider the comparison of two large retail firms in the U.S. Recently, both of these companies had approximately the same ROE (between 20% and 21%). The implication is that both of these companies are equally profitable and, therefore, equally attractive.

But when we examine the source of each’s profitability, we find that (1) one company has outstanding operating factors (margin and turnover) and low debt and (2) that the other company performs very poorly in its operations but enhances this low level of profitability through the use of a high amount of debt. Obviously, we would prefer to invest in the first.

The first company has continued to thrive but the second company has recently gone into bankruptcy due to a decline in sales (and the heavy debt burden). But we would never had forecasted this if we focused solely on the ROE and did not conduct the breakdown of ROE into the sources of the company's profits.

Ratio Analysis

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