Hi everyone. As we previously discussed, there's four parts to financial statement analysis and evaluation. It starts by building a solid foundation with an introduction to financial statements and SEC filings. We first focused on reviewing the financial statements, discussing what's included in them and how they work together. Then we took a deeper dive into SEC filings, looking at the information that's provided to investors. We now turn our attention to ratio analysis. Ratio analysis teaches us how to put the financial statements to work, to evaluate performance trends, identify risk and opportunities, and benchmark one company to another. In order to maximize the benefit of ratio analysis, we need to understand how they're calculated, what they're telling us, and how to decompose the calculations and the different drivers to make the numbers come to life. There are many types of financial ratios focused on the balance sheet and income statement. Many balance sheet ratios focus on productivity, cash conversion, liquidity, solvency, and coverage to service debt obligations. Several income statement ratios focused on a percent of sales analysis and return metrics, such as return on assets, return on equity, and dividend yields. Before we dive deep into ratios, let's first discuss some general guidelines that we need to apply when performing our calculations. First, the ratio involves the income statement and the balance sheet, where an income statement item is the numerator, and a balance sheet item is the denominator. We take the current period amount for the income statement item and an average over the last couple of years for the balance sheet account. As a reminder, the income statement covers a year. For example, January 1 to December 31st. As such, the current period amount for the numerator is appropriate. However, the balance sheet amount is as of a point in time. As such, timing differences can have a significant impact on the ending balance. For example, depending on the timing of your accounts payable cycle, where bills are either paid on December 31st or January the 1st, your imbalances can vary significantly. As such, we take an average of the current and prior year balances in an effort to smooth out the timing anomalies. Now, if the ratio involves an income statement item on the numerator and denominator, you just take the current period amounts for both. Finally, if the ratio only contains balance sheet accounts in both the numerator and denominator, then we just take the ending balances and do not need to calculate an average. Now that we have the general guidelines under our belt, let's talk about the pros and cons of ratio analysis. Why do we even look at financial ratios? What's their value? In my opinion, the biggest value at looking at ratios within a company is that they allow us to evaluate past trends over time to see if performance is improving or worsening. Also, ratio analysis can be the starting point for building a future forecast. For example, if you observe a consistent trend over time, it would be reasonable to assume that that trend will continue and you can incorporate the ratio into your forecast, and ultimately, into your evaluation. Ratios also allow investors to measure the effectiveness of a company's performance and the success of a management team as to how they stack up against a peer company. Finally, ratios can highlight risk and opportunities for a business. Providing key insights on liquidity, productivity, and performance trends. It's obvious, ratio analysis can be a very powerful tool. However, there are some limitations. My main piece of advice is not to fall in love with ratios. They can be dangerous if accepted blindly and not put in the proper context. In order to perform a thorough analysis, you'll need to decompose the ratios to uncover the drivers. It'll allow you to assess if the calculations match the company's strategies and align with their business life cycle. It's also important to understand that there are some inherent limitations that need to be considered when analyzing ratios. For example, there are GAAP limitations. Research and development for the most part is expensed when incurred, but these activities could drive significant future value. Therefore, an increase in R&D spending will appear as a negative in profitability, but could actually be a very positive indicator for future growth. Also, company changes such as mergers, acquisitions, and divestitures can create significant volatility in reported results from one year to the next which may create havoc with ratio calculations and their comparability over time. Similarly, one time items can also impair the compatibility of ratios over time. Next, company life cycle. It's important to put the company's life cycle in the context when analyzing ratios. For example, startup companies are often in investment mode. As such, their return on assets, return on equity may initially look horrible because they should as they are investing heavily in their business and not yet generating sales and profits. Think of a startup pharmaceutical company with heavy research and development investments and little sales. If you relied solely on ratios, you would never invest which could be a missed opportunity. Another example is Amazon. Several years ago they were in heavy investment mode. As a result, many of their return and profitability ratios were not favorable. If an investor did not take into consideration their strategies and life cycle, no one would have ever invested in them. However, the results of the ratios did align with their strategies which proved to be a wise investment. Also keep in mind that ratios are backward-looking based upon past results. The past results may not be indicative of future performance. Think of Kodak. As they began experiencing a decline in the demand for cameras and film, and as we saw a shift to smartphones and digital devices, many of their past ratios appeared fine, but there was definitely trouble ahead. Finally, it's important to realize that peer company comparisons are difficult to find. No two companies are exactly alike. Also, companies often report things differently in their SEC filings. For example, some companies may list SG&A, research and development, and advertising a promotion expense separately, while others may combine all three within a single income statement line item. In summary, ratio should be used as one of many inputs into your analysis, not as the sole basis for an investment decision. To wrap up our discussion, I wanted to summarize the key takeaways. First, focus on the trends within a company and then compare those trends with peer companies. Next, you have to put the results of your ratio analysis into context. Meaning do the results align with their strategies and their company life cycle. Third, decomposition of the ratio is important. This allows you to more clearly understand the drivers and benchmark performance from one company to another. Finally, be aware of the limitations that we discussed so that a misinterpretation does not lead to a wrong conclusion. Calculating, understanding and evaluating ratios can be a powerful tool as part of financial statement analysis and valuation.
