How can you tell whether one company is more solid than another?
For the previous article in this series I summarised the basic valuation measures. This week we will have a look at ratios to measure profitability and financial strength.
Profitability ratios
There are as many possible measures as there are lines in the income statement, but to minimise as far as possible the number of calculations and comparisons, I prefer to concentrate on just two ratios which measure different aspects of profitability.
Operating margin
This is operating profit divided by sales.
Operating profit is struck after the cost of doing business, but before interest and tax. The ratio measures the ability of a company to turn sales into profit.
A single figure for operating margin is not very useful in isolation. It is more valuable:
- to examine the trend for a single company;
- to compare companies in the same sector; and
- to look at the ratios in a whole sector, to understand its financial dynamics.
The operating margin may reflect such things as:
- whether an industry is high or low margin;
- if a sector has a high asset turnover;
- how efficient one company is compared to another; and
- if prices are coming under pressure, e.g. because of competition.
Return on capital employed (ROCE)
This ratio measures how effectively the capital invested in the business is turned into profit, and is the ratio of profit divided by capital, which includes shareholders' funds and borrowings.
Profit and capital can be measured in several different ways. The Quotes and Data section of the Fool website uses operating profit and a measure of capital derived by adding borrowings and provisions to net assets, and deducting intangibles.
As with operating margin, ROCE is more useful in examining trends, or comparing companies, than a single figure in isolation.
ROCE is related to operating margin through the asset intensity of a firm, that is, the amount of assets it needs for each pound of sales. Companies in highly asset intensive industry (such as heavy manufacturing) need high operating margins to make reasonable returns on capital: companies with low asset intensity (such as supermarkets) can achieve reasonable returns on capital with low operating margins.
Financial Strength Ratios
Investment appraisal is as much about assessing risks as it is about scoping the upside. Financial strength is an important ingredient in this. How robust are the company's financials to withstand short or long term setbacks?
I like to measure financial strength in terms of the level of borrowing, the cash flow, and the asset backing. Two ratios are typically used to measure borrowings:
Net gearing
Gearing measures the ratio of a company's borrowings to its shareholders' funds. Yet again, there are numerous ways of calculating the gearing ratio. It is usually presented as net gearing, meaning that cash is deducted from borrowings.
Sometimes net borrowings are divided by shareholders funds, so a ratio of 50% would mean that net borrowings are half of shareholders funds. That would be a reasonable ratio in many industries.
Sometimes net borrowings are divided by shareholders funds plus debt. In that case a ratio of 50% means the debt is equal to shareholders' funds. That would be quite high in most sectors.
Interest cover
Interest cover is a measure of how easily a company can pay the interest on its debt, and is calculated as operating profit divided by interest paid.
If the level is less than 4 times then it is worth looking closely at how reliable operating profits are, and a ratio below 2 times is danger territory.
Interest cover is generally a more reliable measure of borrowings than gearing. Gearing can be distorted by different accounting treatment of items such as goodwill, and is liable to manipulation through window dressing the balance sheet.
Cash flow
Cash flow is vital to the survival of companies.
Growth companies tend to absorb cash, whilst mature, value companies throw cash off. So there is no correct level of cash generation, but it is important to understand the flow of cash.
For a single measure to encapsulate cash generation, I divide net cash flow from operating activities by operating profit. Whether this ratio is above or below one gives you a quick feel for whether the company is absorbing or generating cash from its business activities.
Asset backing
Comparing the company's assets to its market capitalisation (or asset per share to share price) is a good make sense check to ascertain how much you are buying substance, and how much you are paying for future expectations.
Some investment styles place emphasis on tangible assets supporting the share price, and look at tangible assets per share. But in today's knowledge economy, some intangible assets such as brands and intellectual property can be equally valuable.
Next week, we will apply these concepts to a practical example.
More in this series:
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