See Part 1
Balance sheet ratios
13. Current ratio and acid ratio
Current ratio = current assets / current liabilites
Acid ratio = (current assets - stocks) / current liabilities
An exception to general rule about liquid balance sheets is in the case of companies that operate in cash businesses and are in a position to dominate their suppliers (eg. UK supermarket groups which take cash from customers on a daily basis but enjoy credit terms from suppliers).
14. Debtor Days and Creditor Days
Debtor days = trade debtors * 365 / sales
Creditor days = trade creditors * 365 / cost of sales
Deterioration in credit control over time is a worrying trend.
Asset-based companies and those with long-term contracts may not be suitable cases for analysis.
15. Stock days and stockturn
Stock days = stocks * 365 / sales
Stockturn = sales / stocks
Debtor days, creditor days and stock days or stockturn are also known as working capital ratios. They measure the efficiency with which management is minimizing the amount of day-to-day capital tied up in the form of unsold stocks, uncollected invoices or unpaid bills. As different industries have different stock cycles, the trend in the ratios matter more than its absolute level.
16. Gearing
= (total borrowings - cash) / shareholders' equity
Companies with a stable and reliable cash flow can support higher levels of gearing than those in more volatile business. Overvalued assets can cause gearing to be understated.
17. Price/cash ratio
= maket cap / (cash + short-term investments)
Unlisted investments are harder to sell and should not be counted unless it is obvious that their value is substantially in excess of the value included in the balance sheet. Measuring price to cash ratio over a number of years can demonstrate whether or not the company is generating cash on a regular basis.
For certain types of companies (eg. banks, insurance companies), one important extension of the ratio is to include the balance sheet value of all investments. In the case of insurance companies, it often happens that investors focus unduly on shorter-term underwriting result and ignore the fact that the real value of companies like this lies in the investment portfolio they manage. Because of this myopia, it has sometimes been possible to buy insurance companies shares at a substantial discount to the underlying value of their investments.
Cash per share can be a useful screening mechanism to identify "shell" companies (small listed companies with substantial cash and few other assets) which are often the subjects of "reverse takeovers", where the shell will issue shares to acquire a larger private company, the shareholders of which then control the combine listed company, gaining access to its cash resources and its listing.
18. Burn rate
= Net cash / net cash operating expenses per month
Number of months before a loss-making company's cash resources run out (months to zero cash). In addition to bank cash, it is sometimes acceptable to include short-term investments that are easily saleable and not subject to anything other than very small movement in value. Less liquid investments have no place in the calculation. All borrowings should be deducted to arrive at the net cash figure. Net cash operating expenses excludes those that are solely book entry items such as depreciation of fixed assets.
Calculating burn rates on a half-yearly basis shows how well companies are progressing at generating profits, or reducing losses and controlling their expenses. Companies caught between a high burn rate, dwindling cash, and an unreceptive market face oblivion and are best avoided.
19. Return on Capital Employed (ROCE)
= profit before interest and tax (PBIT) * 100/(net capital employed at prior year-end + net capital employed at latest year-end)
Net capital employed = total assets - current liabilities
Current liabilities are excluded because they are not permanently available capital.
ROCE does not distinguish between the different types of capital on which the return is earned. The figure needs to be set against the companies' respective cost of capital to make a definitive comparison. Unless a company makes a return over and above its cost of capital, it is in effect gradually destroying the capital base of the business.
20. Return on Average Equity (ROE)
= Net profit attributable to shareholders * 100/(equity at prior year-end + equity at latest year-end)
In contrast to P/B, all intangible assets should be included. This is particularly true of any accumulated goodwill that is not recognized on the balance sheet, irrespective of whether it has been written off. If necessary, this should be added back to enlarge shareholders' equity. It is important to include in the deminator all of the capital that has been spent by management, not just what it has chosen to recognize in balance sheet. Thinking of goodwill as extra cash spent on past acquisitions makes it easier to see why it should be included.
The return can be either distributed in dividends or retained within the company. Provided management can produce consistent returns, the higher proportion retained, the more future growth is underpinned.
21. Net tangible asset value (NTA)
= (equity shareholders' fund - goodwill) / year-end shares in issue
Regardless of the different names used (eg. "shareholders' equity", "net assets", "book value" etc.), NTA represents the tangible fixed assets plus current assets less current liabilities, long term creditors and provisions. The difference between these numbers represents the residual assets that are "owned" by shareholders. Goodwill is excluded.
Try to identify any difference between market value of assets and their value as stated in the balance sheet and take note of the valuation dates of assets such as property. These differences can be a source of substantial price appreciation. All that is needed is a reasonable chance for the market to recognize the anomaly at some future date, either via a takeover or through break-ups and spin-offs. Change of management can often be a catalyst for changes in strategy to unlock value. Companies with controlling shareholdings in the hands of a family or individuals are less susceptible to market pressure to unlock value.
22. Premium/(Discount) to NAV
= (Share price * 100/NAV) - 100
If share price > per share NAV: premium, otherwise, discount
Premium or discount to NAV is more frequently used as a yardstick for property investment companies and investment trusts. Whether the shares stand on a premium or discount to NAV depends on how successful or otherwise mangement is at generating consistent growth in assets.
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