Financial ratios are the tools investors use to understand the characteristics of a company. It doesn't take you long to figure out, however, that there are hundreds of different ratios, as well as variations of the basic ratios given the industry you're looking at, the company you're looking at, or even the slant of the analyst.
This makes things confusing for the beginning investor, but it's the nature of the beast with financial analysis. After a while, you get used to the fact that every textbook you open has a different definition of free cash flow, or that retailers don't have receivables (retail is a cash business), so their working capital ratios look a little different.
Don't fight it. This variation allows for the fact that investing isn't static. Companies change and your ability to use ratios smartly, in ways that isolate the relationships you're trying to identify, will improve as you learn to tweak them this way and that, or create new ones, the way the Rule Maker did with the Foolish Flow ratio and the Cash King Margin. Unfortunately, this lack of standardization means that even the categories aren't exact, but they give you a feel for what each ratio is trying to measure.
Ratios fall into three or four basic categories and it's useful to know what they are, just as it's useful to know that the chemical elements are broken into the metals and non-metals, as well as families with similar characteristics (such as the alkaline earth metals, halogens, and noble gases).
Here's what the financial ratio landscape looks like: (Remember, ratios are just relationships between things that help identify number, quantity, degree, or proportion.)
Activity ratios: cash conversion cycle, payables turnover, receivables turnover. These ratios give us an idea what kind of revenues are produced by the firm's assets and how efficiently the firm manages revenues and expenses.
Liquidity ratios: current ratio, quick ratio. These ratios give us an idea how easily the firm can meet its short-term obligations.
Solvency ratios: debt to equity, debt to assets, debt to total capital. These ratios tell us how well the firm is positioned to meet its long-term (more than one year or one business cycle) obligations.
Profitability ratios: gross margin, net margin, return on equity. These ratios tell us what kind of profits are produced by a company's operations. Profits mean cash and cash creates value.
The Rule Maker Portfolio uses five ratios to judge the substance of the companies it holds:
Cash King margin
Cash no less than 1.5 x debt
Foolish Flow ratio
Given the categories presented above, we can break these ratios into categories pretty easily, though there is clearly overlap. Gross margin, net margin, and the cash king margin are basic measures of profitability, though the cash king margin is a liquidity measure as well since it represents cash managers can put their hands on. Cash no less than 1.5x debt is a solvency ratio, and a very high standard. The Foolish Flow ratio is a measure of liquidity and activity.
It's no mistake the Rule Maker ratios measure the basics. None of these ratios is hard to use, yet they cover a lot of territory.
That said, in my opinion, these ratios are a beginning, not an end to understanding a company, and investors should look to enhance these ratios with other measures as they learn more. Some will be industry-specific. For example, a critical measure of asset quality in the credit card industry is net charge offs, or loans that go bad as a percentage of managed loans, so you bet we have to know where Rule Maker American Express (NYSE: AXP) stands (better than the industry average).
Also, the cash to debt ratio doesn't tell me everything I want to know about a company's leverage. Rather, it pretty much eliminates any firm with more than a lick of debt. Another way to look at debt is long-term debt/equity, which gives a more nuanced picture of how a company is capitalized. Does the bulk of its financing come from investors, creditors, or both? If you're wondering how easily a company can meet its short-term debt obligations, then the "times interest earned ratio" is a useful metric. Just look at earnings before interest and taxes as a percentage of annual interest payments.
The bottom line with ratios of course, is that they tell us nothing in isolation. A single ratio from one quarter doesn't convey any more information than an unidentified fingerprint. Not only do we need to know the basic industry benchmarks -- for example, that net margins greater than 10% are uncommon -- but we also need to know how these ratios fare over much longer periods than we typically talk about. Rule Maker manager Todd Lebor recently suggested looking at average Rule Maker ratios over one full business cycle to better understand the real financial characteristics of Rule Makers. It's a solid idea.
Have a great day.
Richard McCaffery doesn't own shares of American Express, but he uses many ratios in his daily life to gauge efficiency and effectiveness. One basic yardstick measures the number of dumb things he does relative to the number of dumb things he says. It's higher than the industry average. The Fool is investors writing for investors.