There are many financial ratios that, when combined, can display the real financial circumstances of a company.
Like tools in the garden shed, each has their specific use:
• Liquidity ratios indicate the company’s ability to continue trading;
• Borrowing ratios reflect on the impact debt has on the company’s operations;
• Efficiency ratios give some clues as to the effectiveness of the company’s use of its assets and resources;
• Profitability ratios show the role of various costs in delivering returns;
• Market value ratios calculate whether the share price is “cheap” or “expensive” on a fundamental basis.
There are many websites that will give you the popular ratios and help you unmask the ‘financials’ by explaining what they mean.
Start by doing this with one company. Think about the answers the ratios give. Does it make sense that the stock takes 3 years to turn over? Or that total liabilities exceeds shareholders’ equity?
Repeat the process for other similar companies to discover which management team seems to be the more successful. How has this evolved over time? What are the trends? Who does a better job with the sales dollar? What has the market thought of this performance using the market value ratios?
Once you understand this, the qualitative part of the annual accounts start making more sense. What is the company planning to do to lift profits? Is it about increasing sales or reducing borrowings or better use of assets? Think about what a change in one of the factors will make to the bottom line.
Fundamental analysis leads to value investing. How does the company size up against those like it? Is the company good or poor value at its current level? Is the price/earnings (P/E) ratio high? This ratio simply tells you how many years of profits you are buying. High P/E ratios reflect that profit growth is expected to be strong, but they can be a trap as the price may have over-reached the future potential. Buying a low P/E does not always indicate a cheap stock. It may be low because the company’s prospects are unattractive.
Reading the balance sheet tea leaves (ratios) and knowing management’s story about the past and the future must be done together. ‘You can’t have one without the other’.
It is probably true that the best long-term investors have used these ratios to work out their long-term holdings. The director’s financial report can sometimes not display the real story. Then the ratios fall into the category of ‘garbage in, garbage out’. Study similar companies to get a whiff of what that garbage might be.
Ratios also tell another story: the quality of the management including the directors. In most companies you are buying the skills of managers to grow a business. Some companies can be in the right place at the right time but being a successful shareholder is mostly about constantly using these tools to mark the quality of management. Always look at how the senior management are rewarded. The structure of their remuneration package will tell you which ratios they are focused on. Make sure that this is your focus too.