Picking Apart the Financials —Easier Than You Think
Identifying the appropriate methods for performing your own fundamental analysis can and should be a straightforward process. The calculation of formulas is not always necessary. You can get many popular fundamental tests from published sources. The most popular, the price-earnings (PE) ratio, is listed in most financial papers on a daily basis. However, you should understand not only the elements of a formula but the meaning of the results.
What Financial Statements Really Show
Financial statements prepared by generally accepted accounting principles (GAAP) use many safeguards to ensure complete accuracy. Routines important to ensuring the integrity of financial statements are
• bookkeeping procedures to ensure against fraud or inaccuracy;
• checks and balances to prevent any one employee from exercising too much individual discretion;
• requirements for documentation through invoices, receipts, vouchers, and statements;
• approval procedures in advance of payments;
• procedures for handling receipts to ensure proper safeguards; and
• review and approval procedures through internal auditing departments.
In sum, these safeguards and procedures, while time-consuming and labor-intensive, ensure that by the time financial statements are published, they have gone through numerous internal control procedures. One of the functions of an independent audit is to review all of these procedures to make sure they are adequate.
The first important test that should be included in every fundamental analysis program is the current ratio. This ratio tests a company's working capital by comparing current assets and liabilities. To compute, divide total current assets by total current liabilities. Expressed in the form of comparative factors, the minimum acceptable current ratio in most cases is 2-to-l or better. (The current ratio is one of the few tests having a minimum.) The formula for finding a current ratio is summarized in Figure 5.1.
This is one of the universal tests that should always be applied to the latest financial statement. As a general rule, if a company's current ratio falls below 2-to-l, it may be a danger signal. The current ratio, like most tests, should never be the sole test of a company's financial strength, but should be reviewed as a part of a larger fundamental analysis.
FIGURE 5.1 Current Ratio (rounded to one decimal)
The 2-to-l rule does not always apply. In many industries, a company may exhibit a current ratio of l-to-4 (an inverse ratio, or one with a negative first factor), yet still have excellent financial strength. The attributes of a specific product or service line have much more to do with financial strength than a generalized rule, so application of current ratio should always be done in comparative form—to prior periods as well as to competitor companies in the same industry—and always in combination with other fundamental tests.
KEY POINT
The current ratio is a standard test that should be included in your program-—but never as the sole test of a company's financial strength.
Some problems that the current ratio might not reveal or worse, might mask, include that of excessive current assets. When companies have too much cash on hand, that means they may be managed poorly. Perhaps the cash should be used to pay down liabilities and reduce interest expense, for example. If a company's outstanding accounts receivable are too high based on sales levels, or if it is taking too long to collect outstanding accounts, that will artificially inflate current ratio without revealing the serious problem. And if inventory levels are too high, that can also point to problems in managing working capital, but it will not show up in the current ratio.
A variation of the current ratio is the quick assets ratio, also called the acid test. This is identical to the current ratio with one important exception: inventory is excluded. This test is appropriate when a company, by the nature of its business, does not have any inventory (a financial services company, for example), or when inventory tends to be so long-term that the current ratio is distorted. The general standard calls for a quick assets ratio of 1-to-l or better.
The formula for the quick assets ratio is summarized in Figure 5.2.
In the figure, the quick assets ratio is 1.1-to-l. It surpasses the minimum test that current assets should equal current liabilities (1-to-l), worthwhile reasons to increase the debt capitalization of an operation, but only if that move improves profit margins as well.
FIGURE 5.3 Debt/Equity Ratio (rounded to one decimal)
KEY POINT
The debt/equity ratio can serve as a red flag. Watch out when the debt portion is rising over time, when profits remain at the same margin levels or, even worse, when profit margin begins to fall.
The ratios above should serve as the basic balance sheet ratios worth following, in addition to the even more common statement of income tests such as: sales, net profits, and net margin.
