This week’s value investing weekly will focus solely on the application of Ben Graham’s text Interpretation of Financial Statements. This is a great book because it acts as both a quick reference tool as well a great cover to cover read. The edition that I will be quoting is the classic 1937 edition which was published right after Security Analysis. The section I want to highlight this week is the appendix in the back of the book that details ratio analysis for both a balance sheet and income statement. There are fourteen ratio calculations that Graham highlights as he analyzed Bethlehem Steel Corp. in 1928. This may be simply review for some, new material to others, or a combination of the two, but it is important when debating investing in a company to understand how to manipulate and utilize the publicly available information to better your investing decisions. I also included some commentary that Graham added on the analysis of Bethlehem for better understanding of how he analyzed this firm.
A) Margin of Profit
Calculation-Operating Income divided by Sales
Location-Both found on the income statement
Utilization-Used to determine the operating efficiency of the company. For example if the ratio was 10% it would mean that for every dollar of sales the company has 10 cents left after paying all costs of operation. Note that this amount does not include payment of interest on bonds nor dividends on equity.
B) Earnings on Invested Capital
Calculation- Total Income available for interest charges divided by the sum of Bonds, Preferred Stock, Common Stock, and earned surplus
Location- Total Income found in the income statement, and the remaining figures found on the Stockholders Equity portion of the Balance Sheet.
Utilization- Once the ratio is determined that number (ie: 5%) represents the money earned on the investment of the business.
C) Times Interest Charges Earned
Calculation-Total income divided by interest charges.
Location- Both are found in the income statement.
Utilization- This is used to determine the amount of times interest payments can be covered by income before taxes. Graham felt that for an industrial company such as the one he was analyzing he preferred at least three times interest payments could be paid by income before taxes.
D) Times Interest Charges and Preferred Dividends Earned
Calculation- Total income divided by the sum of interest charges and preferred dividends.
Location- All three figures can be found in the income statement.
Utilization-This is similar to calculation “C” but with the addition of preferred dividends into the equation. Graham required a four times ratio for an industrial company such as Bethlehem Steel.
E) Earnings per Share on the Common Stock
Calculation-Net income after deduction of interest and preferred dividend charges divided by the number of shares outstanding.
Location-Net income is found in the income statement and the amount of outstanding shares is found in the balance sheet.
Utilization- This equation is widely known and used as it shows the dollar amount left over to the common stockholders after all debt obligations and preferred shareholders have been paid.
F) Depreciation as a Percentage of Cost of Plant
Calculation-Deprecation divided by cost of plant (property account).
Location- Deprecation found in the income statement and property account found in the balance sheet.
Utilization-This may or may not be used in all situations as Graham was analyzing a firm with high fixed assets that were tangible. If, however, you encounter a similar firm (ie: manufacturing, distribution, etc.) look for as high a ratio as possible as that tells that the average life of all items in the property account, which includes real estate, are longer.
G) Depreciation as a Percentage of Sales or Gross Revenues
Calculation-Depreciation expense divided by sales.
Location- Both are in the income statement.
Utilization-Graham describes this ratio as a valuable tool when comparing two securities within the same industry.
H) Net Income Transferred to Surplus as a Percentage of Net Income Available for Dividends
Calculation- Net surplus after payout of dividends and interest payments divided by net income before dividend payments.
Location-All relevant information can be found in the income statement.
Utilization- Use this over a period of years to determine if the company has maintained a conservative dividend policy. Could potentially be very interesting when looking at the aggressiveness of dividend payments by a firm.
I) Inventory Turnover
Calculation- Sales divided by inventory.
Location- Sales figure is found in the income statement and inventory figure is found in the balance sheet.
Utilization- The more times a firm can turn its inventory over the less capital is invested in inventory, and there is less of a chance of obsolete material.
J) Number of Days Average Account Receivable is Outstanding
Calculation- Account Receivable divided by net daily sales (Income (Sales) divided by 365 (days in a year).
Location- Account receivable found in the balance sheet (asset side) sales found on the top line of the income statement.
Utilization- Shows the credit policy of the company clearly. You want a firm that has the lowest days outstanding as it shows an aggressive credit department and speaks loudly of management and their priority.
K) Current Ratio
Calculation- Current assets divided by current liabilities.
Location-Both items are found in the balance sheet.
Utilization- Shows the liquidity of a firm and how well they can pay off their current debt with the assets on hand. Important to ensure solvency in terms of short term debt financing.
L) Quick Asset Ratio
Calculation- Current assets less inventory divided by current liabilities.
Location- All items are found in the balance sheet.
Utilization- Another indicator of the financial strength of a company, more specifically the ability to pay off short term liabilities (ie: payroll, rent, utilities, etc.). The higher the number the better off the firm is in meeting these obligations.
M) Book Value of Common Stock
Calculation- The sum of common stock and surplus divided by the number of shares outstanding.
Location- All figures can be found in the balance sheet.
Utilization- This figure usually is of little concern, but should be checked because in cases where the book value is much larger or much smaller than the market price. Further, it must be noted that intangibles such as patents and goodwill is not included in book value of common stock.
N) Price-Earnings Ratio or Market Ratio
Calculation- Share price of the stock divided by the earnings per share.
Location- Share price found from current market price of the firm. Earnings per share are calculate by dividing earnings by the total number of shares outstanding.
Utilization- This is an extremely useful calculation as it tells the investor how many times the stock is trading relative to earnings. Of course as a value investor we want this figure to be as low as possible (preferably under 15).
The above ratios can be used by anyone relatively easily. Not all figures will be appropriate for all firms, but one should use as many ratios as possible when comparing a security to their peers and industry as a whole. There are of course numerous other ratios that can be used, but I merely wanted to highlight the ratios that Graham specifically mentioned with the text. If you feel that any other ratios would fall under this umbrella of value ratios, please feel free to submit your comments.
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