Part 3 of this series has to do
with Solvency and Profitability Ratios. First, a word about
solvency, or leverage ratios. Leverage is using a small
amount of effort or force and obtaining a big result, like
we see in this little guy using leverage to move a huge stone. Leverage in business is
basically the use of debt to finance all or
part of the business. Leverage multiplies the
result, so with more leverage, earnings are multiplied
for a greater return to the shareholders. Remember, the goal of a business
is to maximize the equity value for the shareholders,
or, in the case of a public company,
the share price. And increasing the return to
shareholders will do this. However, the use
of debt increases risk, so I have this
symbol of a scale. We have to balance the
risk and the reward, because when times are
bad and there’s a loss, leverage caused by debt
will also multiply the loss, so there always needs to be
this balance between risk and reward. The first long term
solvency, or leverage ratio, is the debt ratio. It helps to answer the
question, can the company meet its obligations
over the long term? The debt ratio helps
answer the question, how much debt is
being used to support the business versus
shareholder’s equity, or what I like to think of
as other people’s money? The debt ratio is
total liabilities divided by total assets, and
I calculated these ratios from the latest
year end reports. Microsoft has a
debt ratio of 0.45. Apple at 9/29/12 had a
debt ratio of 0.33, or 33%. That means that a
third of Apple’s assets were financed by debt, and about
2/3 were financed by equity. The higher the ratio,
the more the risk. So Microsoft has a greater
debt ratio, and thus a little bit more
risk than Apple. Is this good or bad? Well, use of debt can be good,
because it magnifies the return to shareholders. I find both 0.45
and 0.33, you know, in a very conservative and good
range for technology companies. This ratio will vary
greatly between industries. Technology companies
can be riskier than other types of
companies, such as utilities, and investors– or actually,
banks and bondholders are more reluctant to lend
to technology companies. So you will see less debt. Take a look at Boeing, as of
their last financial statement on 12/31/12. They have a debt
ratio of 0.93, or 93%. That means that 93% of their
assets are financed by debt. This is a very high ratio,
and this is one reason, even though Boeing has great
returns to the shareholders, I consider it risky, and I would
not want to invest in Boeing. Who uses this ratio? Basically, long term lenders,
such as banks and bondholders. Investors use it to
assess risk, as well. Another long term
solvency ratio, which I indicate as new
because it’s not in your book, is the debt to equity ratio. And this measures
a similar thing. How much debt the
company is using compared to the
shareholder’s equity. We take total
liabilities, divide it by total owner’s equity. I got these ratios from Reuters. I indicated that
this is an MRQ, which means calculated for
the Most Recent Quarter. Again, we see Microsoft at
19.76, and Apple at 13.75. My calculations, based on the
balance sheets, are different. But you can use this as a
relative gauge of leverage. So we see, again, consistent
with our calculations, that Microsoft is more
leveraged than Apple. Looking at Boeing,
chose a ratio of 127.27. Again, very high. Fastenal, a company
we saw a ratio before, conservative company with
a very high current ratio, they show a total debt
to equity ratio of zero, very little debt used,
very little leverage, very conservative. This is a case of
apples to oranges. You cannot compare the total
debt to equity ratio with the total debt ratio
that you calculated. They are entirely different,
although they do give you an indication about
the same thing. But this is the one that’s
publicly available up on Reuters. The third leverage ratio
is times interest earned. And this is kind of
a safety measure. This measures how many times
could the interest expense be paid out of earnings
before interest and taxes? Before basically
running out of money. As of 9/30/13, neither
Microsoft or Apple reported. So we just saw these
dashes at Reuters. I look at that as meaning that
they have offset the interest expense to with interest
income or earnings from short term
investments, therefore measuring interest
expense at zero. So they’re not reported. OK? I took a look at Boeing. Boeing had a ratio
of 25.19, which meant that Boeing could
pay its interest 25 times before running out of earnings
before interest and tax to pay interest. I put a little
exclamation mark down here at the lower left hand
corner because in this case, the higher the ratio means the
less risk, the lower the ratio means more risk. In other words, lenders
want to see the ability to pay the interest as many
times over as possible. Profitability ratios
give us an indication of how well has the
company performed overall. And these are all
very important ratios to management, investors,
banks, and analysts. Basically, to everyone. First, the profit
margin shows the amount of profit earned from
sales and other operations. Very dependent on the industry. I’ve shown Microsoft and Apple,
pretty high profit margins, with Microsoft at 28
versus Apple at 22. Microsoft’s is higher. It’s better. You would see a profit
margin, if you thought of just the grocery
part of a grocery, the profit margins
there are pretty slim. Maybe 2%. Maybe 5%. So it really depends
on the industry. As another example, Boeing,
a manufacturer most recently of the Dreamliner. Profit margin of about five,
so substantially different than Microsoft and Apple,
these technology companies. Another very important
profitability ratio is return on assets. That is the amount of profit
earned on each dollar invested in assets, and it measures
management sufficiency using its assets. So, net profit after taxes
divided by total assets. Return on investment
for Microsoft, 16.58. Apple, 20.81. So the return on assets
is better for Apple than on Microsoft. The higher the ratio the better. Again, used by many
types of users. Boeing, as a side note, has
a return on assets of 4.84%. Or– yeah. And this is given as a percent. So I’m going to go back in
and put percent signs in here. Apple’s ratio of 20.81% means
that for every $100 invested in assets, they’re earning
$20 net profit after taxes. Return on equity. It’s the amount of profit
earned on each dollar invested by the shareholders. Again, the result
is a percentage. So Microsoft, for
every $100 invested, is earning $30 net profit. Apple, $32. So Apple has a higher return
on equity than Microsoft. Boeing, because of its leverage,
has a 63% return on equity. Even though the profit margin
was lower, the return on assets was lower, because
of that leverage, they have driven up
their return on equity. Who uses this? Again, management,
investors, banks, analysts, but for an investor,
return on equity, a return on their investment
is a very important ratio.