QUALIPORT
Useless Financial Ratios

By Maynard Paton (TMFMayn)
September 8, 2003

Operating margins, return on equity, creditor days -- the stock market is full of ratios for analysing listed companies. But some are undoubtedly better than others. While the Qualiport has its favourites, the following aren't among them.

1. EBITDA to anything

Stay away from EBITDA -- Earnings Before Interest, Taxes, Depreciation and Amortisation. EBITDA essentially reflects operating profit plus depreciation, which as Warren Buffett explains in his 1989 Shareholder Letter, ignores the existence of capital expenditure:

"Using this sawed-off [EBITDA] yardstick, the borrower ignored depreciation as an expense on the theory that it did not require a current cash outlay.

Such an attitude is clearly delusional. At 95% of... businesses, capital expenditures that over time roughly approximate depreciation are a necessity and are every bit as real an expense as labour or utility costs...

Capital outlays at a business can be skipped, of course, in any given month, just as a human can skip a day or even a week of eating. But if the skipping becomes routine and is not made up, the body weakens and eventually dies. Furthermore, a start-and-stop feeding policy will over time produce a less healthy organism, human or corporate, than that produced by a steady diet."

Colt Telecom (LSE: CTM) provides a good EBITDA example. The telecom group's latest full-year figures boasted of 2002 EBITDA improving 190% to £71.5m. However, that performance excluded the impact of a whopping £812m depreciation charge. Even if you considered the £812m figure to be unduly excessive, capital expenditure of £412m still says Colt has a long way to go before being operationally profitable. Read more.

2. Gearing

Gearing has traditionally been the way of gauging a company's debt level. However, the measure has a major flaw: it doesn't tell you how easy the company can service the interest payments on that debt.

Gearing is determined by expressing the company's debt as a percentage of its equity base:

               Total debt
Gearing = ------------------- (%)
          Shareholders' funds

The higher the percentage, the greater the debt worry.

But consider the latest annual results from media group Emap (LSE: EMA). Borrowings of £237m and shareholders' funds of £248m give a gearing figure of 96% -- very high by normal standards (anything over 50% is viewed by many as 'too much debt'). But Emap's £192m operating profit and £17m interest payments equate to 11 times interest cover, which is very comfortable.

Gearing calculations are only useful for businesses that could be forced to sell their assets to clear their debts. For investors looking for superior asset-light business, as opposed to firms on the brink on bankruptcy, gearing is a very misleading ratio. Read more.

3. Current/Quick Ratio

The current and quick ratios are two more measures from yesteryear. Both attempt to assess a company's 'liquidity':

                    Current assets
Current ratio =   -------------------
                  Current liabilities


                  Current assets - Stock
Quick ratio =     ----------------------
                    Current liabilities

A current ratio of 1 or more is regarded by some as prudent to maintain creditworthiness, the theory being that if short-term liabilities became due immediately, enough money could be raised from stock, debtors and cash in the bank to pay them off. (The quick ratio assumes any stock available can't be sold in time.)

But businesses have changed over time and investors should nowadays hope to see little in the way of cash tied up in unsold goods (stock) and outstanding invoices (debtors), and as much money on supplier credit as possible. The classic example is a supermarket, whose customers pay cash on purchase while the food suppliers wait months for their money. An extract from Tesco's (LSE: TSCO) balance sheet is shown below:

February 22nd 2003                         (£m)

Current assets
Stocks                                    1,140
Debtors                                     662
Investments                                 239
Cash at bank and in hand                    399
                                       --------
                                          2,440

Creditors: falling due within one year   (5,372)

Though nobody would question the company's financial strength, Tesco's current ratio is a 'worrying' 0.45.

For signs of cash flow trouble, shareholders should instead inspect the company's reconciliation of operating profit to net cash inflow from operating activities. This is Tesco's reconciliation:

                                           52 weeks 2003
                                                 £m

Operating profit                               1,484
Depreciation and amortisation                    602
Increase in goods held for resale               (129)
Decrease in development property                   3
Increase in debtors                              (28)
Increase in trade creditors                      238
Increase in other creditors                      205
                                            --------
Net cash inflow from operating activities      2,375

No problems there with a £286m inflow of working capital cash. Read more.

More: Help With Analysing Reports And Accounts