How to Read a Balance Sheet: Price-to-Book Ratio, DSO, and Turns
The last three ratios that you can derive from the balance sheet are the Price-to-Book Ratio, Days Sales Outstanding (DSO), and Inventory Turnover. We saved them for last because they're the most complicated.
Perhaps the least valuable ratio of these three is the venerable Price-to-Book Ratio. Conceived in a time when America was made up mainly of industrial companies that had actual hard assets like factories to back up their stock, its utility has waned in the past few decades as more and more companies that are not very capital intensive have grown and become commercial giants. The fact that Microsoft (Nasdaq: MSFT ) doesn't have very much in the way of book value doesn't mean the company is overvalued -- it just means that the company does not need a lot of land and factories to make a very high-margin product.
Traditional book value is simply the shareholders' equity divided by the number of shares of stock outstanding. In order to look at the company as a whole, you can use the aggregate market capitalization of the company divided by the current shareholders' equity. You can also look at something called Enterprise Value, which is market capitalization minus cash and equivalents plus debt. The reason you subtract cash and equivalents from market capitalization is because if someone were to actually buy the company, they would get all the cash the company currently has, meaning it would effectively be deducted from the cost after the transaction was closed. The enterprise value (EV) to shareholders' equity (SE) looks like this, then:
EV/SE = ((Shares Out x Price) + Debt-Cash) / Shareholders' equity
This number will get you a simple multiple, much like the price/earnings ratio or the price/sales ratio. If it is below 1, then it means that the company is selling below book value and theoretically below its liquidation value. Some value investors will shun any companies that trade above 2 times book value or more.
Days Sales Outstanding is a measure of how many days worth of sales the current accounts receivable (A/R) represents. It is a way of transforming the accounts receivable number into a handy metric that can be compared with other companies in the same industry to determine which player is managing its receivables collection better. A company with a lower amount of days worth of sales outstanding is getting its cash back quicker and hopefully putting it immediately to use, getting an edge on the competition. To figure out DSO, you first have to figure out Accounts Receivables Turnover. This is:
A/R Turnover = Sales for period / Average A/R for period
Sometimes you will only be able to get the accounts receivable from the last fiscal year, and therefore will have to use the revenues from the last fiscal year. However, the fresher the information, the better. What this ratio tells you is how many times in a year a company turns its accounts receivable. By "turn," we mean the number of times it completely clears all of the outstanding credit. For this number, higher is better. To turn this number into days sales outstanding, you do the following:
DSO = Current accounts receivable / (Sales for period / Days in period)
This tells you roughly how many days worth of sales are outstanding and not paid for at any given time. As you might have expected, the lower this number is, the better it is for the company. By comparing DSOs for various companies in the same industry, you can get a picture of which companies are managing their credit better and getting money in faster on their sales. This is a crucial edge to have because money that is not tied up in accounts receivable is money that can be used to grow the business.
The same is true of Inventory Turnover. The less money that's filling up your distribution channels, the more money you will have to do all the other things a company needs done -- marketing, advertising, research and development, acquisitions, expansions, and so on. You want a company to turn its inventories as often as possible during the year in order to free up that working capital to do other things. To figure out how much a company is turning its inventory, you need to find out the Cost of Goods Sold (COGS) for the past 12 months. COGS is the second entry in the Consolidated Statement of Earnings right below the revenue line. Just add up the last four quarters worth of COGS and then find out the current inventory level. If you have problems finding these numbers, a call to the company's investor relations department will usually get you the information you need.
Inventory turnover = Cost of goods sold / Average inventory for period
If two companies are the same in every way but one is turning over its inventories more often, the one with better inventory management is the one that is going to be able to grow faster. Inventory management actually is a bottleneck for growth if it is not efficient enough, tying up a lot of working capital that could be better used elsewhere. If you can find out a company's DSO and inventory turns relative to its peers, you will have an incredible view into how well the company can fund its own growth going forward, thus allowing you to make better investments.
For more lessons on reading a balance sheet, follow the links at the bottom of our introductory article.