Do you remember the first time you buy a house or rent an apartment? I bet that it was not an easy task because you needed to compare many options before making your final decision. Although these buildings may look differently, there are certain criterion which can help you decide which one is the best. Like buildings, no matter how much different companies are, you can evaluate them by using financial ratios.
In fundamental analysis, investors use a wide range of financial ratios to assess companies’ financial health. Even though there are many financial ratios, they all belong to five groups: liquidity, leverage, efficiency, profitability, and market value. Each group shows one aspect of companies’ financial status. With these helpful ratios, 401(k) and IRA investors will confidently build profitable portfolio.
Today, I will introduce the simplest but efficient representative from each financial ratio group and show you how to understand their meanings. In order to have a comprehensive view about Walmart’s financial ratios, we will compare the company with 4 companies: Costco, Target, Disney, and Microsoft. I choose two Walmart’s competitors in its industry and two companies who operate in other industries so you can see how universal financial ratios are in fundamental analysis.
1.Current ratio (Liquidity Group)
Financial ratios in liquidity group show a company’s ability to pay back their liabilities. To simplify the definition, these ratios are similar to credit scores of individuals when they make a loan.When companies borrow money from financial markets and banks, their lenders absolutely look at these ratios first. The most common ratio in this group is current ratio. Current ratio shows the relationship between current assets and current liabilities, as shown below:
Current ratio= Current assets/ Current liabilities
In order to calculate this ratio, we have current assets divided by current liabilities in the same fiscal year. You can get data of both items from balance sheets. As a rule of thumb, this ratio should be greater than 1. Specifically, the larger the ratio is, the better a company’s finance is. Now, we will see current ratios of Walmart and other companies:
Chart 1. Current ratios of companies in 2019.
The chart displays current ratios of these companies in 2019, except Disney. Annual fiscal years of Disney end in September. Unfortunately, at the time I write this article, Disney has not submitted their 10-K form for 2019 yet. Because I know that you, my loyal readers, are eager to learn about financial ratios as soon as possible, I decide to use Disney’s 2018 financial statements. Besides, fiscal years of Walmart often happen between February of the previous year to January of the current year so a time lag between companies is not significant.
From the chart, Microsoft is outstanding with the highest current ratio among five companies. Unluckily, Walmart has the lowest current ratio, when compared to its competitors and two other companies. Both Walmart and Target’s current ratios are approximate and lower than 1. Even though Costco’s current ratio is slightly greater than 1, you can see that retail and wholesale companies in 2019 have difficult time to maintain a healthy current ratio. We discussed industries’ systematic risks in the third article, now we can apply what we learned. Whenever we evaluate a company, we should compare it with other companies in the same field. In this case, although Walmart’s current ratio is quite undesirable but its competitors do not have significantly higher results. Moreover, in 2018, the current ratio of the company was 0,76 so it improved after one fiscal year. Therefore, this ratio is acceptable in this year, but the company needs to increase it in the future to ensure liquidity and calm worried investors.
2.Debt ratio (Leverage Group)
Leverage, what a weird name for a financial term, isn’t it? It sounds more like the invention of Archimedes, the famous Greek mathematician, and does not likely relate to our topic. However, this group actually gets its name from Archimedes’ discovery in physics due to its characteristic in financial fundamental analysis. Financial ratios in leverage group often show relationships between debt and other items such as assets, equity, and income. In other words, these ratios describe percentages of debt in a company’s financial structure and how the company “leverages” their borrowed money to generate income. Debt ratio, a ratio describes the relationship between debt and assets of a company, is the most popular member of this group. Its formula is as simple as its name:
Debt ratio= (Total liabilities/ Total assets) * 100%
When you look at this formula, you may think that debt ratio is a reverse version of current ratio, don’t you? If current ratio indicates liquidity or an ability to pay back short-term liabilities by using short-term assets, debt ratio tells a different story. This ratio points out how many percent of total assets are funded by total liabilities because total assets= total liabilities+ total equity. From debt ratio, we can know clearly about financial structure of a company: what kind of fund that company prefers.
Chart 2. Debt ratios of companies in 2019.
From the above chart, only Disney has the lowest debt ratio (46%), while the others’ assets are dependable on liabilities (over 64%). Especially, companies in the retail industry fund their operations with more liabilities than their equity. Although debt can bring tax shield benefits for companies like I mentioned in the seventh article, this strategy is a double-edged knife. Rising interest rates or recessions can put companies in stressful situations to pay back their debt on time. The debt ratio of Walmart in 2019 was the lowest even though the amount of debt Walmart owes was higher than Costco and Target. Fortunately, we know that the company funds its assets less than its competitors in percentage, which means the company prefers equity to liabilities. Generally, if debt ratio is over 80 to 85% for a company, investors should be cautious because the company borrows too much money. Moreover, if its current ratio is lower than 1, that company can be in trouble to declare bankruptcy in the near future.
3.Asset turnover ratio (Efficiency Group)
After evaluating companies’ liquidity and debt-assets structure, analysts often look for efficiency in companies’ operations. Financial ratios in this group tell investors how well companies manage its assets to generate revenues and reduce costs. Like we discuss above, no matter how much money companies borrow to fund their assets, the key point is that they use the assets in the optimal way or not. At the beginner’s level, asset turnover ratio is sufficient enough for us to understand about this group. In order to calculate asset turnover ratio, the formula is described:
Asset turnover ratio= (Net revenues/ Average total assets) * 100%
When you look at this formula, this ratio clearly shows the relationship between net revenues and total assets, which you need to collect data from both statements of income and balance sheets. You may ask yourself what average total assets are. If you remember, data in statements of income and balance sheets is incompatible. The former has periodic data, the latter has data on a specific date. Therefore, we need to transform data in balance sheets into the same type as statements of income. For example, if we want to calculate asset turnover ratio of 2019, the detailed formula should look like this:
Asset turnover ratio 2019= [Net revenues of 2019/(Total assets of 2019+ Total assets of 2018)/2]* 100%
Average total assets are equal to sum of total assets in 2019 and 2018 divided by 2 so now the data is compatible with net revenues. Then, if you want to calculate asset turnover ratio of 2018, you will need total assets of both 2018 and 2017. Most ratios in efficiency group have the similar formula like this one. As a result, you need financial statements of at least two consecutive years to do horizontal comparison for these ratios. Now you understand why I carefully remind you about characteristics of data in statements of income and balance sheets. Next, we will see how our five companies’ performance through this ratio:
Chart 3. Asset turnover ratios of companies in 2019.
According to the chart, Costco uses its assets to generate revenues the best. For instance, for every 100 cents of assets, the company earns 89 cents of revenues. Second from the top is Walmart with 61 cents of revenues per 100 cents of assets. Target is far behind its competitors. Disney and Microsoft do not perform well with this ratio. Please remember that this ratio only shows the relationship between revenues and assets, it often means that how well sales and marketing departments of these companies operate to increase sales of products or services. In order to know if a company’s business is profitable or not, we need to look into profitability group.
4.Return on assets (Profitability Group)
Profitability group provides financial ratios which indicate how much net income companies earn from using their assets and equity. Two popular ratios in this group are Return on Assets (ROA) and Return on Equity (ROE). The formulas of these ratios are shown below:
Return on assets= (Net income/ Average total assets) * 100%
Return on equity= (Net income/ Average total equity) * 100%
These formulas are similar to asset turnover ratio, but we replace net revenues with net income. Average total equity is calculated the same way like average total assets which I mention above. In order to show how profitable Walmart is and the relationship between its revenues and costs, in this article, I will focus on ROA.
Chart 4. Return on assets of companies in 2019.
If asset turnover ratio points out how excellent companies use their assets to generate revenues, ROA indicates the relationship between net income and assets after subtracting expenses. As you can see, Walmart earns less than 1 cent of net income per 100 cents of its assets although the company gains 61 cents of revenues when we calculate the asset turnover ratio. The significant gap between two ratios, which is approximate 60 cents, represents the company’s costs. For all companies, every cent of revenues that they generate is accompanied by costs. These costs include costs of goods sold, operating expenses, interests, income taxes, etc. We discussed these items in the fifth article, you can review these contents if you forget.
According to the chart, Walmart’s costs are nearly equal to its revenues. It means that the company spends a lot of money in order to sell its products and services. Costco and Target face the same situation. Even though these companies have high asset turnover ratios, their ROAs are only 2,1% and 1,8%, respectively. On the other hand, Disney and Microsoft have higher ROAs despite of their lower asset turnover ratios. Importantly, Microsoft earns 3,6 cents net income per 100 cents of assets, which is highest among five companies. Obviously, Microsoft minimizes their costs the most: less than 8 cents of costs to create 12 cents of revenues. From these ROAs, we can draw another conclusion that retail companies face high pressure of costs. In order to boost sales, these companies need to spend much money first. Therefore, a tip for long-term investments in retail industry is to find out which company has low-cost. By carefully examining their annual expenses, you can predict if these companies will be profitable or not in the future. In other words, the higher their costs are, the lower dividends you may receive. Now, we move on the last financial group, market value ratios.
5.Earnings per share (Market value group)
Whenever you watch stock market news or view business websites, the frequent ratios you see belong to this group. We can name a few of them, such as earnings per share (EPS), dividend yield, and price-earnings ratio (P/E). Among them, EPS is the most crucial ratio that 401(k) and IRA investors should focus on. I also introduced EPS briefly when we learned about statements of income. Now we look at its formula again:
EPS= Net income/ Weighted-average common shares outstanding
A quick remind for you is that companies often issue and repurchase their outstanding stocks during a fiscal year so their stocks on the market change frequently. As a result, companies must calculate the average of their common stocks based on the time the stocks exist on the market. Statements of income always provide this data and EPS so you do not need to calculate by yourself. The only task you need to do with EPS is to do horizontal comparison and competitor comparison.
Chart 5. Earnings per share of companies in 2019.
Like we analyzed in the sixth article, Walmart’s EPS has surged for years due to acquisition costs, store closures, and losses from divestiture in foreign markets. The company’s EPS is lower than not only its competitors but also companies in other industries. Using EPS to compare between companies is a fair and efficient method because we can eliminate their capital sizes and industries’ characteristics. For instance, Walmart’s capital value is larger than Costco and Target but the company performs inferiorly. Generally, larger companies often have more resources and market shares than smaller ones so they have more advantages and better performance. However, in 2019, this belief is not true for Walmart. Therefore, as an investor, instead of evaluating a company by its capital size or reputation only, you need to examine financial ratios to obtain a comprehensive view about the company.
After this article, you know some common and helpful financial ratios which support you to invest efficiently. In the next article, we discuss statements of cash flow, the last important statement in 10-K forms.
Kha Le
Previous articles in the series:
- What are financial statements and why do 401(k) account owners need to understand them?
- A structure of a financial report (Form 10-K)
- Business and risks, inseparable parts of every company
- Smart investors act like wise consumers
- Dive in statements of income- Part I
- Dive in statements of income- Part II
- Balance sheets or nightmare sheets
Reference
- Walmart INC. (2019). Form 10-K. Retrieved from the U.S Securities and Exchange Commission website:https://www.sec.gov/Archives/edgar/data/104169/000010416919000016/wmtform10-kx1312019.htm#s073C519522825BC493B6BBF7F16C874B
- Costco Wholesale Corporation (2019). Form 10-K. Retrieved from the U.S Securities and Exchange Commission website:https://www.sec.gov/Archives/edgar/data/909832/000090983219000019/cost10k9119.htm
- Target Corporation (2019). Form 10-K. Retrieved from the U.S Securities and Exchange Commission website:https://www.sec.gov/Archives/edgar/data/27419/000002741919000006/tgt-20190202x10k.htm#s072FB9F2AA8A546C8A4574D25AF4AB08
- Microsoft Corporation. (2019). Form 10-K. Retrieved from the U.S Securities and Exchange Commission website:https://www.sec.gov/Archives/edgar/data/789019/000156459019027952/msft-10k_20190630.htm
- The Walt Disney Company. (2019). Form 10-K. Retrieved from the U.S Securities and Exchange Commission website:https://www.sec.gov/Archives/edgar/data/1001039/000100103918000187/fy2018_q4x10k.htm
