Fundamental Analysis

Fundamental analysis uses a company’s financial statements to determine the value of the company with regard to its potential growth in earnings. Fundamental analysts use projected forecasts of the economy to focus on industries that are expected to generate increased sales and earnings. Companies within those industries are evaluated to determine which stocks to buy.

The financial statements provide the basis for ratio analysis, which assists in determining a company’s strengths and weaknesses. Ratio analysis uses a company’s financial information to predict whether it will meet its future projections of earnings. Although ratio analysis is simple to compute, its projections and extrapolations can become complex. Ratio analysis is a tool that can assist you in your selection of stocks. From financial ratio analysis, you can assess a company’s past and present financial strengths. Then, armed with this information, you can project trends by using each of the five groups of ratios:
* Liquidity ratios illustrate the ease with which assets are converted into cash to cover short-term liabilities.
* Activity ratios show how quickly the assets flow through the company.
* Profitability ratios measure a company’s performance.
* Leverage ratios indicate a company’s level of debt.
* Common stock–related ratios relate share price information.

Table 10–5 provides a list of the different ratios in each of these groups to use to evaluate a company’s strengths and weaknesses.

Liquidity

Liquidity is defined as assets that are easily convertible into cash or a large position in cash. Although liquidity is of greater concern to a company’s creditors, this is a starting point for a potential investor in a company’s common stock. Liquidity indicates the ease (or difficulty) with which a company can pay off its current obligations (debts) as they come due.

The current ratio is a measure of a company’s ability to meet its current obligations. It is computed by dividing the current assets by current liabilities. The current ratio shows the coverage of the company’s current liabilities by its current assets.

Acompany’s current assets generally should exceed its current liabilities, so that if its current assets decline, it can still pay off its liabilities. A low current ratio might indicate weakness because the company might not be able to borrow additional funds or sell assets to raise enough cash to meet its current liabilities. Yet there are always exceptions to a low current ratio. ExxonMobil, one of the strongest companies in the oil industry, in some years has had its current ratio fall below 1. However, ExxonMobil has always had the capacity to borrow on a short-term basis to pay off its current obligations. In those years, the notes to the ExxonMobil financial statements showed that Exxon had unused lines of short-term financing with its banks and could issue commercial paper. Potential investors should always read the footnotes, which contain additional information that provides more insight into the figures on the financial statements.

Moreover, you should not look at a ratio for one period in isolation. By examining past current ratios, you can establish a trend and see more easily whether the most recent current ratio has deteriorated, stayed the same, or improved over this period. What might be the norm for one industry might not hold for another. Utility companies tend to have current ratios of less than 1, but the quality of their accounts receivable is so good that virtually all the accounts receivable are converted into cash. (Most people pay their utility bills; otherwise, they find themselves without power.) Creditors of utility companies are therefore not as concerned with low current ratios. Similarly, ExxonMobil’s liquidity was not significantly different from that of the rest of the oil industry, which suggests that the oil industry typically has current ratios of around 1 or less of current assets to current liabilities.

The quick ratio is a more refined measure of liquidity because it excludes inventory, which is typically the slowest current asset to be converted into cash, from the current assets in the calculation. The quick ratio is always less than the current ratio unless the company has no inventory. The quick ratio indicates the degree of coverage of the current liabilities from cash and other, more liquid assets. A low quick ratio indicates that the company might have difficulty in paying off its current liabilities as they become due. However, this statement might not always be true because many other factors influence a company’s ability to pay off current debts:
* Its capability to raise additional funds, long or short term
* The willingness of its creditors to roll over its debt
* The rate at which current assets such as accounts receivable and inventory turn over into cash

Activity Ratios

Activity ratios measure how quickly a company can convert some of its accounts into cash. This type of ratio measures how effectively management is using its assets.

Accounts receivable turnover indicates the number of times within a period that a company turns over its credit sales into cash. This ratio gives an indication of how successful a company is in collecting its accounts receivable. This ratio is computed by dividing accounts receivable into annual credit sales. The larger the accounts receivable turnover, the faster the company turns over its credit sales into cash. For example, an accounts receivable turnover of 17 indicates that sales turn over into cash every 21 days (365 days/17), or 0.7 times a month (12 months/17).

Inventory turnover measures the number of times a company’s inventory is replaced within a period and indicates the relative liquidity of inventory. This ratio gives an indication of the effectiveness of the management of inventory. The higher the inventory turnover, the more rapidly the company is able to turn over its inventory into accounts receivable and cash. For example, an inventory turnover of 7.8 indicates that it takes the average inventory 47 days to turn over (365 days/7.8). If the inventory turnover for the same company increases to 9, the inventory turns over in roughly 41 days (365 days/9).

With both the accounts receivable turnover and inventory turnover you do not want to see extremely low values, indicating that the company’s cash is tied up for long periods. Similarly, extremely high turnover figures indicate poor inventory management, which can lead to stock-outs (not having enough inventory to fill an order) and therefore customer dissatisfaction.

Accounts payable turnover indicates the promptness with which a company makes its payments to suppliers. This ratio is computed by dividing accounts payable into purchases. If information on purchases is not available, you can use the company’s cost of goods sold minus (plus) any decreases (increases) in inventory. The accounts payable ratio indicates the relative ease or difficulty the company has in paying its bills on time. If the average terms in the industry are “net 30 days” and a company takes 50 days to pay its bills, you know that many of the bills are not being paid on time. Table 10–6 discusses how a company can alter its balance sheet to make the company more liquid.

Profitability

Acompany’s profits are important to investors because these earnings are either retained or paid out in dividends to shareholders, both of which affect the company’s stock price. Many different measures of profitability indicate how much the company is earning relative to the base that is used, such as sales, assets, and shareholders’ equity. The different profitability ratios are relative measures of the success of the company.

Table 10-6
How a Company Can Improve Its Financial Position by Sprucing Up Its Balance Sheet at Year-End
Some companies spruce up their balance sheets for their year-end financial statements. Many of the techniques that are used are within accounting and legal limits. One such method is for a company to reduce its working capital through a reduction of inventory levels, accounts receivable, and accounts payable. Working capital is defined as an excess of current assets over current liabilities. If working capital is high, it indicates inefficiency in that resources are tied up in inventory and accounts receivable. Lower levels of working capital are a sign of a company’s efficiency and financial strength because less cash is tied up in inventory and accounts receivable. REL, a London based consultancy group, looked at the balance sheets of 1,000 companies and found that companies could cut their inventories by shipping more products at year-end. In the quarter following, inventories backed up as customers either returned some of the inventory or cut back on their purchases because they had too many goods in stock.
At the same time, companies worked hard at getting their customers to pay their bills faster before year-end. REL found that companies could reduce their receivables by 2 percent at year-end only to have them increase by 5 percent in the quarter following.
Companies paid their own bills, thereby reducing their accounts payable at yearend. REL found that accounts payable fell by 7 percent at year-end only to increase by 12 percent in the next quarter. Assume that a company has $50,000 in total current assets and $40,000 in total current liabilities, resulting in a current ratio of 1.25. If the company pays its accounts payable of $10,000 before the end of the accounting year, current assets will be $40,000 and current liabilities $30,000, resulting in an improvement to the current ratio from 1.25 to 1.33. Any significant reductions in inventory and accounts receivable at year-end should be followed up in subsequent quarters. Answers often can be found in the footnotes and management discussion and analysis sections of the annual report. Has the company been selling its accounts receivables? Although this practice is common among various companies, it can signal that the company is experiencing a cash crunch.
An increase in a company’s inventory level is another red flag. Analyze where the increases are. If they are in finished goods while raw materials have decreased, this is a signal that the company is having trouble selling its goods. On the other hand, if raw materials have increased while finished goods have decreased, this indicates that sales are expanding and that the company is gearing up for an increase in sales.

Using sales as a base, you would compare the different measures of earnings on the income statement. Compare the sales for the period with the sales figures for previous years to see whether sales have grown or declined. For example, sales might have increased from the preceding year, yet the company may report a net loss for the year. This situation indicates that expenses have risen significantly. You would then examine the income statement to see whether the additional expenses were nonrecurring (a one-time write-off) or whether increased operating costs were incurred in the normal course of business. In the latter case, you should question management’s capability to contain these costs. Establishing a trend of these expenses over a period of time is useful in the evaluation process. Several profitability ratios use sales as a base: gross profit, operating profit, and net profit.

Gross Profit Margin
The gross profit margin is the percentage earned on sales after deducting the cost of goods sold. The gross profit margin reflects not only the company’s markup on its cost of goods sold but also management’s ability to control these costs in relation to sales. The gross profit margin is computed as follows:
Gross profit margin = (sales – cost of goods sold)/net sales

Operating Profit Margin< The operating profit margin is the percentage in profit earned on sales from a company’s operations. Operating profit is the income from operations [also known as earnings before interest and taxes (EBIT)] divided by sales. This profit includes the cost of goods sold and the selling, general, and administrative expenses. This ratio shows the profitability of a company in its normal course of operations and provides a measure of the company’s operating efficiency.
Operating profit margin = operating profits/net sales

The operating profit or loss often provides the truest indicator of a company’s earning capacity because it excludes nonoperating income and expenses.

Net Profit Margin
The net profit margin is the percentage profit earned on sales after all expenses and income taxes are deducted. The net profit margin includes nonoperating income and expenses such as taxes, interest expense, and extraordinary items. Net profit is calculated as follows:
Net profit margin = net income/net sales

You might not think that calculating all these profit ratios is important because of the main emphasis on the net profit margin alone. This belief could be misleading because if tax rates or interest expenses increase, or if some large, extraordinary items occur during the year, a significant change in net profit occurs, even though operating profits have not changed. A company could have a net profit at the same time that it posts an operating loss. This situation occurs when a company has tax credits or other one-time gains that convert the operating loss into net income. Similarly, if the net profit margin declines in any period, you would want to determine the reasons for the decline.

Other measures of profitability are the returns on equity, common equity, and the return on investment. These ratios are more specific to common shareholders because they measure the returns on shareholders’ invested funds.

Return on Equity
The return on equity is a measure of the net income a company earns as a percentage of shareholders’ equity. This ratio indicates how well management is performing for the stockholders and is calculated as follows:
Return on equity = net income/shareholders’ equity

Return on Common Equity
The return on common equity is a measure of the return earned by a company on its common shareholders’ investment. When a company has preferred stock, the common shareholders might be more concerned with the return attributable to the common equity than to the total equity. To determine this return, adjustments are made for the preferred dividends and preferred stock outstanding.
Return on common equity = (net income – preferred dividends)/(equity – preferred stock)

Return on Investment
The return on investment is a measure of the return a company earns on its total assets. This return relates the profits earned by a company on its investment and is computed as follows:
Return on investment = net income/total assets

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