Market and investment evaluation methods: Part 3

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By Doug Awad

Part 1 of “Market and Investment Evaluation Methods” reviewed stock market and business basics. Part 2 discussed fundamental analysis including economic, industry, and company analysis. It ended with a definition of “ratio analysis,” a tool security analysts use to measure the investment worth of a company.

This article will review ratio analysis in more detail. Ratios provide a quick way to measure a company’s financial condition. The rations are derived from information contained in a firm’s income statement and balance sheet.

Liquidity: The liquidity of a business is measured by its ability to satisfy its short-term obligations as they come due. If a company can’t pay its bills, it’s in trouble.

Creditors and investors typically begin by reviewing a company’s net working capital. Net working capital equals a firm’s current assets minus its current liabilities.

Current assets include cash, marketable securities, accounts receivable, and inventory. Current liabilities include accounts payable, dividends payable, income taxes payable, and current maturities of long term debt.

Two other ratios used to measure ability to pay bills are:

Current ratio: This measures a company’s ability to pay current liabilities. It equals current assets divided by current liabilities.

A current ratio of 2:1 is often considered acceptable. That means there are $2 of current assets available for every $1 of current liabilities. The acceptable ratio can vary from industry to industry.

Quick ratio: This ratio is called the “acid-test.” It equals current assets minus inventory, divided by liabilities. This ratio provides a better measure of liquidity as it can take several months to liquidate inventory.

Activity ratios (or turnover): Activity ratios can be used to assess the speed with which assets (e.g. inventory, accounts receivable) are converted into sales or cash. The higher the turnover into cash, the better position the company is into pay its bills.

Several rations are used to measure this:

Average collection period: The average age of accounts receivable is useful in evaluating how effective a firm’s credit and collection policy is followed. It measures the speed in which receivables are collected. The faster the better.

The average collection period is determined by dividing the total accounts receivable by the average sales per day.

Receivables turnover: Like the average collection period, this also measures how quickly a company collects its accounts receivable. The formula is: annual sales divided by total accounts receivable.

The larger the turnover receivables ratio, the faster a company turns its sales into cash.

Fixed asset turnover: This measures productivity, or the efficiency with which a firm has been using its fixed assets to generate sales. Fixed assets consist of long term assets such as property, plant, and equipment.

The ratio is computed by dividing a firm’s total annual sales by its net fixed assets. It tells you the amount of sales generated for every dollar invested in fixed assets.

Inventory turnover: This measures the speed with which inventory is sold. Dividing the cost of goods sold by the inventory. A low figure tells you the company is carrying too much inventory or that sales have slowed.

Debt or leverage ratios: When analyzing a company’s debt position you consider the firm’s degree of indebtedness and ability to pay its debts. The more debt a firm uses, the greater potential for both risk and return.

Debt ration measure the proportion of total assets financed by the firm’s creditors. The ratio is calculated by dividing total liabilities by total assets. The debt-equity ratio indicates the relationship between the long-term funds provided by the creditors and those provided by the firm’s owners.

This ratio is calculated by dividing the long-term debt by stockholders equity.

Profitability ratios: There are many ways to measure a firm’s profitability.

1. Operating profit margin measures pure profits earned on each sales dollar.

This ratio is calculated by dividing operating profits (before interest and taxes) by total annual sales.

2. Net profit margin is the percentage of each sales dollar remaining after all expenses – including interest and taxes.

3. Return on total assets (ROA) is also called the firm’s return on investment. This is found by dividing net profits after taxes by total assets.

4. Return on equity (ROE) measures the return on the owner’s investment in the firm. This is net profit after taxes divided by stockholders equity.

5. Earnings per share is the figure with which we are most familiar. This is the number of dollars earned on behalf of each outstanding share of common stock. Simply divide net earnings by the number of shares outstanding.

6. Price/earnings ration represents the amount investors are wiling to pay for each dollar of the firm’s earnings. Divide the market price per share of common stock by the earnings per share. The higher the P/E, the more willing investors are to pay to own shares of the company.

If nothing else, I hope this series about fundamental analysis will enable you better understand research reports when you read them.

If you have questions, call Doug Awad at 854-6866, or e-mail Doug.Awad@raymondjeames.com. He is a resident on the 200 Corridor and his office is on 31st Road, adjacent to Paddock Mall.

This information was partially developed by Forefield Inc., an independent third party. It is general in nature, is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or a solicitation to buy or sell any security.

Investments and strategies mentioned may not be suitable for all investors. Past performance may not be indicative of future results. Raymond James & Associates Inc. does not provide advice on taxes, legal, or mortgage issues. These matters should be discussed with an appropriate professional.