## Financial Analysis 101-155 Ratio Analysis Part 3

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.