Teaching Note 4

Financial Ratio Analysis

Learning Objectives:

1. Read and interpret a simple income statement and balance sheet.
2. Be able to interpret common financial ratios and relate them a firm's strengths and weaknesses though comparative analysis.
3. Explain the differences in profitability measures.
4. Interpret a firm's capital structure - use of leveraging and use of equity.
5. Understand the difference between market share and book value and explain what is meant by "value creation".

Financial Analysis

The student will find financial data for a company in the firm's 10K, annual reports, S&P's and Moody' s publications. To assess financial competencies, a comparison of the firm with others in the industry is helpful. A good source for comparative data is S&P's Industrial Survey, available at the Harvey Library reference desk. This Teaching Note assumes that the student has taken the required Accounting courses and Finance 304 and has a basic understanding of the Balance Sheet and Income Statement. For a quick review of this material go to SBA Office of Womens' Business Ownership where there are on-line interactive lessons accessed in the section USING NAVIGATION AIDS: FINANCIAL STATEMENTS. Also, you might check out "How to Read a Balance Sheet" at The Motley Fool -- a web site for individual investors.

The most commonly used ratios for comparative analysis are explained below:

Market Share - This is a measure of a business's "power". It informs as to percentage of the available customers that the firm has captured. Market share is the Firm's Revenues ÷ Total Industry Sales.

Common-Stock Security Ratios - Sometimes it is helpful to examine a firm's financial performance on a per-share basis. These ratios report various returns for money invested and, therefore, tend to be more useful  to financial investors than to strategic analysts -- declining stock indicators tend to indicate business problems that are already understood by investors.

A stock ratio that is of particular interest to strategic analysts is the Market-to-Book value (M/B) ratio as it  expresses business performance in terms of value creation. The theory, simply stated, is that capital investment should create value for the investor, resulting in a higher value of the firm than indicated by the "book value" of assets. "Book value" is the amount of investment capital reported in the balance sheet; or, stockholder's equity reported at historical (yesterday's) value. The Market Value is the "bid" price to own a share of the firm as reported on the current stock market exchange. When the stock market bids up a stock the company's Market Value is increased. High value of stocks is presumed to be generated by the firm's operations which drives growth, captured in the current stock price: Market value = (contributions from operations) + (contributions from financial policies, mainly debt policy).

Value Line's Beta OR Market Risk - Inconsistent or volatile stock performance can indicate strategic issues to be investigated. Stock volatility is measured by the stock beta (ß). Value Line and brokerage firms such as Merrill Lynch publish the beta coefficient for each stock. This is a measure of the historical volatility of the company's stock as compared against an industry average of 1. A high beta indicates that it is very difficult to predict how the stock will perform in the future.. This does not mean that a high beta stock is, or will be, a poor performer. It only means that the stock price of the stock historically has fluctuated greater than other firm's stock in the same industry. The riskiness is the inability to predict future performance because of stock price volatility. In using the beta risk to evaluate a firm, three facts should be kept in mind:

(1) This is a stock performance measure of risk for the corporation. A diversified corporation presents to the stock investor a portfolio of businesses. The beta of a diversified firm cannot measure risk of each separate line of business, only the aggregate risk of the entire portfolio of businesses held by the corporation. Good, consistent performance by many small SBU's may reduce the of an otherwise volatile, poor performance of the corporation's core business.
(2) The beta (ß) for a company is based on historical data. This may mean very little in assessing future risks.
(3) A firm's individual risk should be evaluated in comparison with an industry beta -- and, an industry beta is usually not reported, because the convention is to assume that the industry beta is 1.

Here are some industry averages from 1981 data showing that risk is partly an industry effect:

The the early 1980's firms in the electronic components industry were changing because of the movement into integrated, micro circuits and semiconductors, and stock prices reflected the ambiguity of this change in technologies. Utility companies, however, historically have been fairly consistent performers -- low risk.