Ratios—What They Are, How They Work

Communicating with numbers alone is difficult, tedious, and often ineffective. You need to gather information that is largely numerical, and express it in some form that makes sense—to you and to everyone else. Those with purely analytical minds will be comfortable with the numbers. However, the majority of investors—even those who follow the fundamentals—are not so analytical that the numbers are enough.

Even the most analytical of minds comprehends information more readily when it is expressed in a form that is easier to digest. A short, concise paragraph may be more revealing than a long column of numbers. A graph or chart tells you more in a glance than a page of dollar values and percentages. This is where the ratio is valuable. A ratio is an abbreviated form of expression that describes the relationship between two or more values. For example, if one number is twice as large as another, the ratio of the two numbers is 2-to-l.

A ratio may be the result of a simple division of one value by another, or it may be a calculation of a more complex formula. In either event, a value derived from the comparison of two other values serves as a useful device for compiling fundamental information, and for enabling yourself to more easily understand the meaning of that information.

w KEY POINT

A number reflects value; a ratio reflects the relationship between two or more values.

Example: This year, sales were $505,916,003 and net profits were $49,492,095. Last year, sales were $425,885,623 and net profit was $44,052,384.

In the above example using numbers alone, it is difficult to comprehend exactly how this year's results compare to last year's. While the current sales and profit numbers are higher, are they better? This depends, of course, on the standard for comparison that you want to use. If that standard is net margin, then the results are not positive. Using ratios like net margin (net profits expressed as a percentage of sales), a year-to-year comparison is much easier.

This year, net margin was 9.8 percent, compared with 10.3 percent last year. Not only is stating the comparison as net margin shorter, it is more precise. It communicates not just the numbers, but the significance of those numbers. You can quickly learn that net margin is down this year. It is not necessary to go through a calculation because the ratio is the result of a calculation that has been done already.

Fundamentals should not be used for short-term decision making, but for management of a long-term portfolio. Indicators are developed from the compilation of consistently developed information. That does not require that you ensure its exact accuracy; it is more important that the information be generally reliable and applied consistently in all cases. The following example will clarify this point.

Example: You realize that the current ratio, as important a test as it is, cannot be considered completely accurate. Because current asset and liability account balances change from time to time, the year-end totals might not be entirely representative. It would be more accurate to perform a current ratio using a 12-month average that is recalculated every month.

While the point is a valid one, do you really want to compile running monthly totals for current assets and current liabilities, and compute a running average each month? It would provide more accuracy, but would it make a significant difference? In this book, a basic premise is that simplified, straightforward information is good enough in most cases, as long as the same approach is used in each and every case.

Every ratio you use should provide you with certain basic things, including:

•   Validity. A ratio must provide you with meaningful information.

•   Value. A ratio also should provide you with information that indicates the latest entry in a trend that you need to follow in order to manage your portfolio.

•   Practicality. If you are to succeed in developing a fundamental program, it has to be simple enough so that you can maintain it.