Developing a Ratio-Based Program

The combination of various ratios provides useful information. Too many people approach the question of analysis by simply following one or two ratios they consider important—and then study those in isolation. This is not an effective way to measure a company's financial performance. Below are a few typical combinations of ratios that may work well together to provide an overview of financial results. They are paired together with the purpose of enabling you to judge various factors at the same time.

Basic approach. This combination includes the ratios that should be in your program without exception. These ratios are the current ratio, the debt/equity ratio, and the dividend payout ratio. You do not want to limit your review to just these ratios, but if you look at nothing else, these ratios provide you with the bare minimum of information and a quick glance at a financial statement, the foundation for your analysis program.

Working capital approach. This method combines the current ratio (and perhaps the quick assets ratio) with working capital turnover and inventory turnover. This approach is especially useful when companies are in significant growth periods—often recognized by large jumps in sales volume. By using working capital tests as a method for monitoring the company, you can anticipate how well operations will be controlled in future, larger volume periods.

Capitalization approach. You also may be concerned when corporations appear to depend heavily on debt capitalization. If long-term liabilities and bonds represent too large a portion of capital, it makes sense to combine the bond ratio, preferred stock ratio, and common stock ratio, as well as watching carefully the trends in diluted earnings per share.

When are bonds too much of total capitalization? One important test is to compare earnings per share and net profit margin at various funding levels. As long as the corporation is able to maintain or improve profits and profit margins with higher debt, there is no problem. The danger occurs when profits and profit margins begin to erode as shareholders' returns are replaced with interest payments to bondholders. Include interest coverage in this approach to watch out for deteriorating relationships between net profit and interest being paid on bonds. This approach monitors the use of profits and capital trends.

Margin approach. Earlier in this chapter, you saw how return on equity is a valuable ratio. It demonstrates how well shareholders fare on their investment performance, rather than comparing profit margins from one year to the next. Under the margin approach, you combine analysis of margins in various forms: return on equity, net margin, and -earnings per share. This approach is useful when done in combination with price-earnings (PE) ratio, because it enables you to track financial results (fundamentals) with market price performance—the perception of fundamental value in the market as a whole. In a perfect world, the margin approach should anticipate the PE ratio in a predictable manner. In the real world of the auction marketplace, you will find that perceptions (market price and PE ratio) anticipate future margin. It is upside down. As a result, the perception may be right or wrong, and only time will tell. However, the margin approach provides you with an excellent method to determine the relationship between fundamentals and market price of the stock.

Growth approach. Tracking growth in sales is valuable because it uses a base year and calculates annual percentage increases. Likewise, tracking the annual changes in earnings per share from a base year clarifies the analysis and smoothes out exceptional years. This is an approach few investors take, because few people understand the importance of creating a base. It is from that base that growth is accurately measured.

The more popular way of measuring growth is from year to year. This is misleading and inaccurate. Each year, by itself, will not be representative of a base or of any relative and meaningful comparison. If you want to track growth and recognize reliable trends, you need to have a base year for virtually all of the fundamental analysis you perform.

For some ratios, like the current ratio, the base is the minimum standard of 2-to-l or better. But for most other types of ratios, a base exists in time (e.g., a base year), and all future analysis grows from that base. So if the base is inaccurate or unreliable, the trend analysis itself will be flawed. Choosing the right base is critically important.