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Course Section 3 - Lesson 6
Financial ratios allow us to leverage our understanding of financial statements and efficiently analyze the operations of our target company and its competitors. These ratios distill key data points in financial statements down to a single number that is easily comparable across time and companies. In this lesson, we will look at how we can use this tool to learn about a company's operations more quickly and more accurately.
The idea behind all financial ratios is the normalization of data. By connecting two related data points and combining them into a single figure, we end up with a result that is both meaningful and comparable.
For example, say we wanted to know how efficiently a company was utilizing its assets. One method of measuring this would be to ask the question: "How much revenue does a company generate for every dollar of assets it has control over?". This is a calculation we could perform across every company in an industry and derive comparable results. For instance, if we ask this question for every company in the casual dining industry (using pre-pandemic numbers), we find:
So what does this table tell us? Well, for every dollar of assets that Cracker Barrell has control of, it generates nearly two dollars of sales. That's great; in fact, it's far better than the industry average of 1.2x. We like to see companies utilizing the capital that they control efficiently. Our target company, Texas Roadhouse, isn't quite as strong, but at 1.4x, it still ranks among the top of its peer group.
Let's take a look at how we utilize ratios to better understand our target company's liquidity, leverage, efficiency, and profitability.
Liquidity ratios help us understand how prepared a company is to meet near-term obligations. Two of the most popular ratios for understanding liquidity are the current ratio and the quick ratio.
The Current Ratio calculated as Current Assets / Current Liabilities, attempts to determine how likely a company is to meet upcoming obligations by comparing all of a company's most liquid assets to liabilities that are to be paid within ~ 1 year.
The Quick Ratio attempts to answer the same question. But it recognizes that inventory and current assets classified as "Other" are more difficult to convert to cash than other current assets. Its formula is a slightly tweaked version of the current ratio: (Current Assets - Inventory - Other Current Assets) / Current Liabilities. This ratio is the more conservative of the two.
Understanding how much debt a company has assumed is critical to understanding how risky a company's stock is. While debt is not necessarily a bad thing, too much debt is. We can use leverage ratios to understand how a company is financing its operations and how its capital structure compares to its peers.
The Debt / Equity Ratio compares a company's debt to its total equity. This ratio provides an investor with an indication of how prevalent debt is in financing a company's assets. A high Debt / Equity ratio, may be an indication that a company has become too leveraged and is taking excessive risk.
The EBIT / Interest Expense Ratio calculates the number of times a company could pay its interest payments from earnings before interest and taxes are deducted. An EBIT / Interest Expense Ratio of 1 indicates that a company will just meet its interest payments with earnings from the core business.
Efficient companies utilize capital effectively. They are good at turning investor's money into more money. When we make investments in companies, we want to make sure we are investing in management teams that have proven they can operate efficiently.
The Asset Turnover Ratio calculated as Total Revenue / Total Assets, tells how many dollars of revenue a company generates for every dollar of assets the company controls. Higher ratios indicate that the company is utilizing assets more efficiently than lower ratios.
The Inventory Turnover Ratio, calculated as Total Revenue / Average Inventory, tells us how many times the company sold all of its inventory, replaced it, and then sold it again during the year. A high inventory turnover ratio indicates that a company efficiently produces and sells its merchandise to customers.
Profitability ratios help us figure out how effectively a company can convert sales into income.
Return on Assets, calculated as Net Income / Total Assets, tells us how much profit a company generates for every dollar of assets the company controls. A high ROA indicates that a company can more profitably deploy assets than a lower reading.
EBIT Margin, calculated as EBIT (Earnings before Interest & Taxes) / Total Sales, indicates the proportion of a company's sales that are converted into profit. Higher EBIT margins are preferable to lower margins because of the reduced likelihood that a business will suddenly turn unprofitable.
Putting the Ratios to Work
Now that we have some familiarity with basic financial ratios let's put them to work on the companies in Texas Roadhouse's peer group to see if we can draw any conclusions about the industry.
The chart below looks at the companies in Texas Roadhouse's industry across the ratios we've identified above. Additionally, I've highlighted more robust ratios in green and weaker ratios in red.
Let's walk down this chart. We'll start with Texas Roadhouse's liquidity situation. At the end of 2020, the company had a current ratio and a quick ratio of about 1. Indicating that total current assets offset current liabilities. Further, because the company's quick ratio was also near one, we can also say that they are just about able to settle current liabilities with their most liquid assets. This is a great signal, and it doesn't give us any cause for near-term liquidity concerns.
As we move down the chart, the next component we come to is leverage. Texas Roadhouse has a debt/equity ratio of .88, indicating that for every dollar of equity the company has, it carries 88 cents of debt. This level of debt is modest, and it is the lowest in its peer group. Further strengthening the argument for a strong financial position, is the fact that TXRH can pay its interest payments more than six times from its 2020 earnings before interest and taxes. Again, this is among the strongest in its peer group. These numbers give us no reason at all to think that the company is over-leveraged.
Continuing on to efficiency, Texas Roadhouse does a great job of translating assets to sales. During the year 2020, which was dominated by Covid-19, the company managed to convert every dollar of assets into revenue. It also managed to turn its inventory over nearly 100 times, about every 3.5 days. These are both excellent numbers and give us confidence that management are good stewards of investor capital.
Finally, if we look at profitability, we see that Texas Roadhouse returned .8% on assets and generated an EBIT margin of 1.1% during 2020. These are the weakest numbers of the entire set, and while it's good that they were positive, they were just middle of the pack compared to the rest of the industry.
In aggregate, compared to its peers, Texas Roadhouse looks strong.