© 2000 John Petroff
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© 2000 John Petroff |
D- Interpreting ratios
When using ratios one should have a thorough understanding of how the industry statistics (i.e. the comparative ratios) were calculated (see, for instance, with regard to this issue Note N-8G2.1). Usually, there will be a definition of each ratio and an explanation of how the ratios were compiled in the industry reference material.
1)- Presentation of industry data:
In RMA's Annual Statement Studies
(at http://www.rmahq.com/),
which is the major source of comparative data for American bank
loan officers as mentioned in Chapter
1 Section D-2c, ratios are presented for a large number of
industries: over 400 industries in the 1994 edition, over 800
in the 1999 edition, with a promise for more industries in the
next issue. Columns of ratios are arranged in three groups:
- by size of assets,
- by size of sales, and
- comparative historical data for the past 5 years.
Each ratio is presented as a set of
3 numbers: lower quartile, median and upper quartile. The use
of these three statistics avoids the pernicious influence of outliers
(i.e. unusual values). Note, for instance, that the median is
not skewed as the mean would be by an unusually high value in
the distribution. Most of the statistical sources (e.g. see information
sources in Chapter 1 Section
D-2c) other than RMA offer mean values with outliers removed.
RMA's statistics also indicate the number of firms in each sample,
which is useful for the analyst to determine how reliable and
representative are the numbers.
When conducting an analysis, comparison is usually made with the industry median or mean. Sometimes, the comparison ought to be with either the upper or the lower quartile number. Naturally, upper and lower quartiles are indicative of a more desirable performance or more serious problem than the middle ground number. Comparison with ratios of unrelated industries is usually not recommended. Especially, no universal statistic or rule of thumb should be used as long as there is a more informative data sources (as illustrated for the current ratio rule of thumb fallacy in Chapter 8 Section D). When studying a company with several very different product lines, choosing a comparative industry is difficult. One approach is use the numbers for the industry of the major product of the company. A more complex and rarely used, but more mathematically accurate approach is to combine ratios of the industries in which the company is active, in the same proportions as the product line sales of the company. See further discussion of industry classification in Chapter 14 Section A.
Ratios are merely comparative measures and do not have meaning in themselves (with a few exceptions, such as days sales outstanding, for instance, as illustrated in Chapter 8 Section G-2). They are used to reveal whether the items in numerator or denominator are adequate, or if, on the contrary, a problem exists. If the value of such an item is out of line with what is expected for such a company (i.e. given the comparative industry numbers), it tells that some management decision is out of the ordinary. It remains for the analyst to determine with the help of other ratios, financial data or interviews, whether this decision was unusually clever or misguided.
See review questions Q-5D.1 through Q-5D1.4.
2)- Using comparative data:
What each ratio is intended to reveal, is the impact which a given value of numerator or denominator will have on future i) earnings, ii) risk and/or iii) growth. These three parameters are indeed the determinants of value, as extensively demonstrated throughout chapters 2 and 3.
No single item or ratio can be fully beneficial on all three
of these counts. To verify this, a brief illustration of the contribution
of various items, in terms of our three parameters can show this:
- large current assets would reduce risk because of the better
ability to meet current obligations, but they contribute little
or nothing to earnings since cash actually decreases in value
with inflation and inventory held too long becomes obsolete;
- large fixed assets are the means of future production and sales,
and thus contribute to growth and earnings, but they constitute
risky uses of funds because their resale value is usually only
a fraction of their cost, and the company will delay cutting capacity
even when sales slump;
- equity is essential for growth, it has no risk because the owners
will never put the firm in default; but, to the firm, it is an
expensive source of funds because dividends are paid after taxes
and shareholders demand a higher return than lenders in compensation
for the higher risk;
- borrowed funds are cheap by comparison to equity because interest
is deductible, but they are risky to the firm, and growth would
be very chancy with only that type of funds;
- sales are the source of earnings and growth, but they depend
on the willingness of customers to purchase the goods, which is
uncertain;
- fixed expenses associated with automation contribute to earnings
by lowering unit costs, but increase risk by being fixed in the
face of possible sales drop;
- finally, research and development expenses lower today's earnings,
but are the source of future growth.
See review question Q-5D2.1.
See research assignment R-5.3.
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