Chapter19

InterpretationofFinancialStatementsTopicsCovered19.1BusinessIntelligence 19.2UsefulSites19.3Focus 19.4ProfitabilityRatios 19.5Valuationratios 19.6ManagementEffectivenessRatios 19.7FinancialStrengthRatios 19.8EfficiencyRatios 19.9Non-FinancialInformation 19.10QuickSummaryofThisChapter 19.1BusinessIntelligenceLotsoflargebusinessesnowadaysaremonitoringtheirreal-timefinancialdataincludingtheaboveprofitabilityratiosbyusingbusinessintelligencesoftwaresuchasSAPBusinessIntelligence,MicroStrategy,Sisenseetc.Thesoftwarecouldcreateauser-friendlyreportandpresentthefinancialandnon-financialinformationonthedashboardinrealtime.19.2UsefulSitesThewebsite

canhelpchoosedifferentratiosandcomparetargetcompany'soneswiththeS&P500averageforadifferentyear.Thiswebsitealsofiltersinformationbasedondifferentindustrysectorsandisquiteuser-friendly.19.3Focus

Focus:theinterpretationofthosefinancialratiosinsteadofthemechanismofcalculations.WebsitelikeI()canhelpsearchforyourfavouritecompanies,wherethosefinancialratiosarepresentedonthesite.19.4ProfitabilityRatios19.4.1GrossMarginCalculation: Grossprofitx100% SalesrevenueThisistheprofitofthesaleoftheproductorrenderingofservice,beforeconsideringanyadministrative,interestandtaxexpenses.Ausefulwebsiteforcomparingthegrossmarginratiosofdifferentindustriesis.Somewaysthatthegrossmarginratiocouldbeimproved:Increasethesellingprice.Reducecostsofsalesbyreducingthematerialscosts,labourcostsandotherproductionoverheadsuchasrentexpense.Reducestockwastage.Offerbonuspaymentstoemployees.Changingthesalesstrategy.Reducethenumberofunprofitablecustomers.Improveinformationsystems.19.4.2OperatingMarginCalculation: Operatingprofitx100% SalesrevenueThisistheprofitratioafterconsideringallinventorycostsandadministrativecostsbutbeforeinterestandtaxpaid.Itissometimesreferredtoasprofitsbeforeinterestandtax(PBIT)orearningsbeforeinterestandtax(EBIT).Theoperatingmargincouldbeimprovedinthefollowingways:Theabovewaystoimprovegrossmargincouldalsoimproveoperatingmargin.Reducethenumberofdealers.Reducingmanagementremuneration.Outsourcecertainfunctions.19.4.3EBITDAMarginCalculation: EBITDAx100% SalesrevenueItisslightlydifferentfromtheoperatingmarginbecausethismeasureenablesinvestorstocomparetheprofitabilityofdifferentcompanies.19.4.4PretaxMarginCalculation: Earningsbeforetaxx100% SalesrevenueTheoperatingmarginofsomebusinessesmaybehighbuttheirpretaxmarginlow.Thedifferencebetweenthesetwoisthatthepretaxmarginalsoincludestheinterestexpenseelementinthecalculation.19.4.5NetProfitMarginCalculation: Profitaftertaxx100% SalesrevenueThisratiomeasurestheprofitafterconsideringallexpensesinabusiness.19.4.6TTM/5YA/3YAInvestors’websites,agencies,andmagazinesmaycalculateandmarkcompany’sratiosasaTTM(Trailing12Months:foroneyear),5YA(onaverageforthepastfiveyears),3YA(onaverageforthepastthreeyears)oronaquarterlybasis.19.4.7VerticalandHorizontalAnalysisThemethodtocalculateprofitabilityratios(grossmargin,operatingmargin,EBITDAmargin,pretaxmarginandnetprofitmargin)iscalledverticalanalysis3.Anothermethodofpresentingtheseratiosistousetrendorhorizontalanalysis.Thismeanstocalculatethechangesoftheseprofitmarginsovertime.19.5Valuationratios19.5.1PriceEarnings(P/E)RatioCalculation: Shareprice EarningspershareThesharepriceisthemarketvalueofeachshare.Earningspershareiscalculatedbydividingtheprofitaftertaxintothenumberofsharesoutstandinganditmeasurestheprofitabilityofeachshare.TwomostcommonlyusedtypesofP/Eratios:P/Eratio(TTM)andforwardP/Eratio.TheP/Eratio(TTM)isbasedonthepastsharepriceandearningsandindicatethesharehasbeenoverpriced.

TheforwardP/Eratioisbasedonthecompany’sestimateofitsfuturesharepricetoearnings.ThisislessreliablethantheP/Eratio(TTM)becauseitisnotbasedonpastinformation.19.5.2PricetoSales(P/S)RatioThismethodrevealswhetherthecompany’sshareisunder-orovervaluedThecalculationistodividethecurrentsharepriceintosalesrevenueandmeansthesuminvestorsarewillingtopayperonedollarofsalesrevenueearned.Thisratiodoesnotincludeexpensesinitscalculation.Henceitwouldbebetterforinvestorstocombinewithotherratiostoevaluateacompany’sperformance.19.5.3PricetoCashFlow(P/CF)RatioCashflowsareusedintheP/CFcalculation.ForsomebusinesseswithlotsofPP&Es,non-cashexpensessuchasdepreciationexpensemaybehigh.SomecompaniesdisclosethepricetocashflowratioinMRQ,whereMRQstandsforthemostrecentquarter.19.5.4PricetoFreeCashFlowRatioThisiscalculatedbydividingthecurrentsharepriceintothebusinessfreecashflow.Thefreecashflowiscalculatedbyusingitsoperatingcashflowsandsubtractingcapitalexpenditure(expenditureacquiringPP&Es),andthismeansthebusinessvalueisdeterminedbycashflowsexcludingthosePP&Es.19.5.5PricetoBook(P/B)RatioorMarkettoBookRatioThisiscalculatedbydividingtherecentsharepriceintothebookvalueoftheequity.Thisratioisusedbyinvestorstofindoutanyundervaluedshares.DifferentviewsabouttheP/Bratios：AccordingtotheviewofFoyeandMramor,thelowertheP/Bratio,thebetter.19.5.6PricetoTangibleBookRatioThisiscalculatedbydividingthecurrentsharepriceintotheequityvalue(similartotheP/Bratiobutitexcludestheintangibleassetsvalue)pershare.Thisisusedincapital-intensivebusinessesratherthanmostservicebusinessessuchasaccountancyfirms,financialservicesorlightassetscomputersoftwarecompanies.Ifthisratioislessthan1,itmayimplythebusinessistradingbelowitstangibleassetsvalueandmaybeundervalued.19.6ManagementEffectivenessRatios19.6.1ReturnonEquity(ROE)Thereturnonequityratiomeasureshoweffectivelyabusinesscouldturnthefinancefromequityintoprofits.Itiscalculatedbydividingthenetprofitsintoaverageequityduringtheyear.Thisrationeedstobecomparedwithcompaniesinthesameindustry.IftheROEishigh,theratiohasbeenmanipulatedintheways:Sharebuyback,Byrelyingheavilyondebtfinance,ProfitinconsistenciesIfthenetprofitinthenumeratorofthecalculationortheequityfigureinthedenominatorofthecalculationisnegative,thiswouldalsomaketheROEnegative.19.6.2ReturnonAssets(ROA)Thisiscalculatedbydividingthenetprofitintototalassetsvalueinabusiness.Thisratioshowshoweffectivemanagementcouldutiliseassetstogenerateprofits.19.6.3ReturnonInvestment(ROI)Thisisthemeasureoftheshareholders’returnfromtheinvestmenttheyhaveinjected.thehighertheROI,themoreattractivethecompanyistoinvestors.However,iftheROIisveryhigh,therisksassociatedwiththecompanyarealsoveryhigh.19.7FinancialStrengthRatios19.7.1CurrentRatioThismeasuresthefirm’sabilitytouseitscurrentassetstosettlethoseliabilitieswhichmaybeduesoon.Thisiscalculatedbydividingthecurrentassets(includingtradereceivables,inventories,prepaidexpenses,cash)intocurrentliabilities(includingtradepayables,taxpayableandotherpayables).Generally,iftheratiocalculatedismorethan1.5,theliquiditypositionofthecompanyisgood.19.7.2QuickRatioThequickratioiscalculatedbydividingtherevisedcurrentassetsbythecurrentliabilities.Thisistoexcludethelessliquiditem,i.e.,inventoriesandaccountingadjustmentsuchasprepaidexpense.Therevisedcurrentassetiscalculatedbyusingthetotalcurrentassetsandsubtractinginventoriesandprepaidexpenses.Normally,ifthisratioisgreaterthan1,thiswouldmeanthatthecompany’sliquiditypositionwouldbesafe.19.7.3TotalDebttoEquityRatioandLong-TermDebttoEquityRatioThetotaldebttoequityratioiscalculatedbydividingthetotalliabilitiesbythetotalequityinthebusiness.Ifthisratioishigh,saymorethan1,thismeansthebusinesshastakenfarmoredebtfinancethanequityfinance.19.7.4InterestCoverRatioThisiscalculatedbydividingtheprofitbeforeinterestandtaxbytheinterestexpense.Generally,iftheratioisgreaterthan2,thiswouldmeanthatthebusinesscouldhaveenoughprofitstocoverthosefinancecostsdue.Bothdebtorlong-termdebttoequityandinterestcoverratiosarecalledgearingratios.19.8EfficiencyRatios19.8.1AssetTurnoverRatioThisiscalculatedbydividingtotalsalesrevenuebyaverageassetvaluefortheyear.Thismeasureshowefficientlythebusinesscouldturnitsassetsintosalesrevenue.Generally,thehighertheratio,themoreefficientlythebusinesscouldturnitsassetsintosalesrevenue.Thisratiocouldbeusedtogetherwithoperatingmargin.19.8.2InventoryTurnoverRatioThismeasureshowquicklythoseinventoriescouldbesoldinagiventimeperiod.Thehighertheratio,thefasterthosestockscouldbeturnedintosalesrevenue.Twomethodsofcalculatingtheinventoryturnoverratio：dividethesalesrevenuebyaverageinventories；dividethecostsofsalesbytheaverageinventories.19.8.3ReceivableTurnoverRatioThisiscalculatedbydividingsalesrevenuebyaveragereceivablebalances.Thenumeratorinthecalculationcouldbethetotals