by George Angell
The two types of financial statements, the balance sheet and the profit-and-loss statement, are at the heart of a sound fundamental analysis of any given company. But you must understand how to move beyond these two benchmark measurements to really understand how the company is doing. The easiest way to interpret a company’s results is by looking at the key ratios which are accepted in the financial community.
The rate of return (ROI) is among the most important of these ratios. This is calculated by taking the profit and dividing it by the investment. Yet this brings up a key question – what, exactly, is profit? Net operating profit, profit after taxes, profit before taxes – all could be profit. The same ambiguity applies to the word “investment”. Are we talking about total assets employed or merely equity? It makes a difference. It is important that a company makes the definitions of these terms clear and that it is consistent in reporting the numbers.
For the sake of illustration, let’s use profit after taxes and total assets. Let’s assume we are looking at company called ABC Technologies. Here’s the calculation to determine ROI:
|.132, or 13.2%
According to these results, ABC Technologies is earning a rate of return of 13.2 percent on its invested capital.
Now, as an investor, you might be comparing ABC with two other investment opportunities. One is a semiconductor company with an ROI of 25.1 percent and the other is a financial services company with an ROI of 7.9 percent. Based on how the sole criteria of ROI, the semiconductor company would win hands down. This is because it is utilizing its invested capital in the most effective way possible.
This is the key to understanding this ratio – how much money can the company make per invested dollar? You should note the following: a company’s net profit on sales may be high; but if the sales volume is low for the capital invested, the rate of return on the investment may be low. This highlights why rate of return is important as compared to simply looking at sales volume, profit on sales, and absolute profit figures. A company that can do more with less is almost always a better investment opportunity than one that requires substantial capital outlays to generate healthy sales.
The rate of return on investment is nothing more than an investment tool for measuring a company’s performance. Its drawback, as with any ratio, is that it measures what has already taken place – not what lies ahead. The idea is to compare the ratio with competing companies. The ROI ratio can also provide you with a glimpse into the trend of a given company. Is it maintaining its ROI? Or is the company making less money on the same investment? In the latter case, you may have an argument for selling the stock if you already own it.
There are two schools of thought on investing in a company that has debt, both of them with merit. You can make the argument that a debt-free company is preferable to one that has debt. A company without debt is unlikely to be pushed into bankruptcy. That is a big plus for investors. But the general rules for undertaking debt that apply to consumers likewise apply in the corporate world. So-called “good” debt, on the other hand, is when you use the borrowed funds to finance a depreciating asset, such as an automobile, a holiday in the Caribbean, or to purchase expensive jewelry. The bottom line: will the asset be worth more in the future? When it comes to corporate debt, the same guidelines should be observed. Yet, since almost all profit-making enterprises have the same corporate goal – to earn profit – the use of those funds to generate revenues and profits down the road must be uppermost in management’s mind.
On the other hand, responsible debt can be exactly what the doctor ordered. A company that can successfully utilize borrowed funds can grow more rapidly than a conservative company that doesn’t use other people’s money to ramp up operations. When it comes to analyzing a company’s debt, perhaps the best way is the middle way: While too much debt can spell disaster; too little debt suggests slow growth. The key is management’s ability to use the debt effectively. It comes down to trust in management.