# Finance 1, Analyzing Financial Statements in the Annual Report Using Ratios: Part VII of "Learnin's From My MBA" Series

About 2 months ago, we started a series called "Learnin's From My MBA." The series is meant to take the business concepts I have learned in my MBA program and present them to you, an audience of scientists with very little business background.

In the last 2 months, we've done an analysis of each and every part of an annual report. Throughout, I treated it like an anatomical dissection and little else: We opened up the report, "labeled" each part of it, and got a basic understanding of what each separate part did, and what it was connected to. This week, we delve a little deeper. Now that you know all the parts, the vocabulary, and the basic elements of the annual report, we can do some analysis.

As usual, we'll be using a real-live company as an example--Alta Genetics, a small Canadian biotech firm. This series is designed for readers to work along with the information contained here, by downloading and following from their Annual Report.

If you're just starting this series, you should probably go back to the first installment and do them in order: The series is meant to be cumulative, and this week's segment will not make any sense until you've learned the basic anatomy and vocabulary in an annual report.

Ratio Analysis

One of the easiest ways of analyzing an annual report is through the use of mathematical ratios. Ratios between line items are compared to "industry standards," or to ratios of similar companies, to find out whether the company being analyzed is better than, worse than, or in the middle of the pack.

There are four basic attributes that are commonly analyzed using financial ratios. They are "liquidity," "leverage," "turnover," and "profitability." Used together, you can get a pretty good idea of the health of a firm, relative to the industry it is in.

Liquidity

Liquidity ratios are used to determine the company's ability to pay its bills from day to day. By calculating these ratios, we get a good idea of the basic functionality of the firm--if they owe \$4 million next week, and they've only got \$20 in the bank and no more money coming in, it really doesn't matter how good the company's prospects are in the long term: They're not going to last past next week.

Two of the most commonly used liquidity ratios are the "Current Ratio" and the "Quick Ratio." The Current Ratio is calculated by dividing current assets by current liabilities. Remember that "current assets" are assets that are cash or will be converted into cash in the next 12 months. Current liabilities are amounts owed in the next 12 months. So if the Current Asset:Current Liability ratio is less than 1, chances are, the company isn't doing very well--they can't pay back all the money they owe with the cash they'll have on hand and will have to start selling long-term assets, or look at refinancing the company, in order to pay their short-term bills. Doing this ratio for Alta Genetics gives us 2.1--so the current assets are two times the current liabilities.

The second liquidity ratio is the Quick Ratio. It's just like the current ratio, but inventory stores aren't counted as a current asset. Sometimes, inventories build up on statements and are worthless or very hard to get rid of in real life--if you had \$400,000 worth of 1980s computers, they'd be kind of hard to get rid of at the retail value. Because of the unreliability of inventory values, a lot of people use a Quick Ratio instead of a Current Ratio to determine liquidity. Remember that even though this number will always be lower than the Current Ratio, it doesn't mean the company is doing worse, because you're comparing this company's Quick Ratio to the industry average Quick Ratio, and every other company's number will have been calculated without inventory as well.

Alta Genetics has a quick ratio of 1.2, so if inventories aren't counted, their current assets are just barely covering their current liabilities.

Leverage

Two of the most commonly used ratios for evaluating leverage are the Debt Ratio and the Times Interest Earned ratio.

The debt ratio simply takes the total assets less the total equity (basically, the total debt), and divides it by the total assets. The ratio gives a percentage of the company that is financed by debt. For example, a company using 28% debt will be said to be more leveraged than a company using 10% debt in its capital structure. Alta Genetics' debt ratio is 64%.

The Times Interest Earned ratio compares the amount of interest that is owed every year to the amount of money earned before interest and tax. By dividing Earnings (before interest and tax) by the interest paid that year, an analyst can get a good idea of what percentage of the company's earnings is being used to finance debt. If you're only making \$100, but owe \$110 a year in interest, you're not doing nearly as well as if you only owed \$10 a year in interest. By seeing how much earnings are going back to the company and how much are going to the creditors, you can get a pretty good idea of how leveraged the company is. For Alta Genetics, the Times Interest Earned ratio is 1.32, so a good deal of the money earned this year is going straight to the interest expense [a fact that is very much consistent with the high (64%) debt the company is carrying].

Turnover Ratios

Turnover ratios calculate the approximate "utilization" of assets. They give you a look into how well the company is managing things like its inventory levels, the accounts receivable on its books, and the like.

There are three very commonly used turnover ratios. They're all really the same calculation but for different items on the balance sheet.

Inventory Turnover

By dividing the "cost of goods sold" line item by the inventory line item, you get what's known as an inventory multiple. For example, if you've got \$50 worth of stuff in inventory, and your cost of goods sold (essentially your costs of inventory for the year) was \$500, you get an inventory multiple of 10 times. This means that, every year, you "turn over" your inventory 10 times. By dividing the number of days in the year by this number, you get the number of days the average piece of inventory sits on the shelf: In our example above, 365/10 = 36, so the average piece of inventory stays on the shelf a little longer than a month.

Inventory turnover is key in high-tech industries, where inventory becomes obsolete very quickly. It also gives a bit of an indication as to the competency of management: If they're making too much or too little stuff, they're probably not running their company properly.

In the case of Alta Genetics, their product is not quite as high-tech and probably has a long shelf life, so their inventory turnover of 267 days isn't quite as high as it appears.

Receivables Turnover

Receivables turnover does the exact same thing as inventory turnover but looks at the Accounts Receivable line item. Remember, this line item indicates the amount of money your clients owe you for stuff they've bought but not paid for yet.

By dividing sales by accounts receivable, you get a multiple just like the one in inventory turnover. By dividing the number of days in the year by this number, you get an idea of how long your average receivable lasts. For example, if your sales were \$500 for the year, and you had accounts receivable of \$50, your average accounts receivable age would be 365/(500/50), or 36.5 days. This means that the average customer only pays you back 36.5 days after they've purchased the item.

Although receivables turnover, like all of these ratios, is highly dependent on the industry you are in (a good ratio for the biotech industry may be an awful ratio for General Motors, and vice versa), you can still get an idea of what's going on in the company by using it. It gives you an idea of how reliable your customers are with payments and how good the management team is--if they're forgetting to get paid by their clients ("letting receivables slide"), they're not doing a good job.

The average age of accounts receivable at Alta Genetics is just over 90 days. Although this seems high at first glance, it may not be that high for the industry they're in and would have to be compared to other companies in this specific field.

Payables Turnover

Payables turnover is a measure of how long the company is waiting before paying off the people that it owes, so it's the complete opposite of receivables turnover. Calculated the same way, it gives the average length of time before the company is paying its bills. If this is too short, the company may be missing a really good opportunity for financing (because postponement of paying for stuff you buy is, in effect, financing--just ask any student). If it's too long, it's usually a sign of trouble. You don't want to make your suppliers mad: If they cut off the supply, you can't make any money.

In the case of Alta Genetics, it's impossible to determine the age of their payables due to the amalgamation of payables and "accrued liabilities" as one line on their balance sheet. If the number given on this line were just accounts payable, the average time before a bill is paid would be over 6 months!

Profitability Ratios

Profitability ratios ask one easy question: Is the company making money? There are all sorts of different ratios to look at this. We're going to be discussing three of the most common--profit margin, return on assets, and return on equity.

Profit Margin

Profit margin asks one simple question: Of all the stuff you sold that year, what percentage was pure profit? We calculate profit margin by dividing net income (the bottom line--after all expenses, etc., the amount of money retained by the company through sales that year) by sales (the amount of stuff sold). For example, if your net income at the end of the year, after all your expenses, taxes, and such, was \$30, and you sold \$300 worth of stuff this year, your profit margin would be 10%. Profit margin is useful for measuring a whole variety of things. First, if you can figure out your competitions' profit margin, then you've got a pretty good idea of whether they're making more or less money than you for selling the same amount of stuff. That is, if your competition has a profit margin of 30% and you've only got 10%, it's going to be very hard for you to compete: If your competition wants you out of the market, they could just lower their price by 20%, giving them a profit margin of 10% (still profitable) and making yours -10% and driving you to bankruptcy.

Profit margin is also a useful tool when a firm is growing rapidly. As your sales go up, what happens to your expenses? If your profit margin is shrinking as you're growing, you may be becoming less efficient.

Alta Genetics, like many biotech start-ups, is unfortunately currently suffering from a negative profit margin. However, the profit margin has been improving: down to -1% from -6.5% in 1996. Thus the company is at least moving in the right direction.

Return on Assets

Return on Assets (ROA) gives an idea of how much money you're making, given the size of the company. The easiest way of figuring this out is by dividing net income by the total assets of the company. If your Return on Assets is less than the interest rate, you'd be better off selling all your stuff and putting the cash in the bank, unless you felt it was going to improve significantly, soon.

Because Alta Genetics posted a loss last year, the return on assets is also going to be negative. However, this is normal with a small biotech firm: People are willing to accept a negative ROA in the first few years, in exchange for a high upside potential in the years to come.

Return on Equity

Return on Equity gives an idea of how much the firm is making per dollar invested in it by shareholders. The easiest way of calculating it is by dividing net income by total equity. If shareholders can make a higher return on equity elsewhere, you may be in trouble: They may decide that some other company is a better investment for them and pull out their funds.

Again, the Return on Equity is negative in the case of Alta Genetics--theoretically, you'd be making more money if you put your savings in the bank. However, the investors are likely in it for the long haul, hoping that when the company starts making money, it'll make lots.

Summary

This week, I've tried to give you a fairly simplistic look at some of the basic tools analysts use when evaluating an Annual Report. If the series has interested you, and you want to go further in the analysis, I suggest getting an introductory text on Corporate Finance. Because going on in this subject will get more detailed than most of our readers can stand, in next week's "Learnin's," we're going to move on to another subject: Marketing. So stay tuned!

### Charles Boulakia

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