Welcome back to my series on fundamental analysis, a way of evaluating companies as investments based on their financial statements. It differs from technical analysis, which relies on trends in price charts to evaluate possible investments. 

So far we’ve discussed how to read a company’s balance sheet, income statement, and cash flow statement. We’ve also dug into some key statistics like EPS, P/E, and PEG.

Today we’ll start looking at key ratios management and analysts use to check the company’s economic health. Today’s post will look at liquidity and profitability ratios and use them to explain a huge price decline in CAT, our example stock.

Why CAT?

If you’ve wondered why I picked Caterpillar (NYSE:CAT) as an example, take a look at this CAT chart (below - click here for a larger 2007 chart) up to the date its 2007 financials were released:

This chart indicates CAT’s fundamentals were strong from at least 2003 through 2007 – the kind of runup in price it saw during that period is just too unlikely for a mature company with weak fundamentals.

However, take a look at CAT’s recent dive-bomb (below - click here for a larger 2008 chart):

The price leveled off from 2006 to early 2008, then crashed in a big way. Why? Can fundamental analysis help us figure out what happened?

To start answering that, let’s first walk through some commonly used ratios, starting with those that measure liquidity. You might be surprised by how many ratios are involved; most are best evaluated in comparison to industry averages or as evidence of an emerging trend.  While we won’t review every ratio, we will hit some key ones, then start dissecting CAT’s huge drop.

LIQUIDITY RATIOS

Current Ratio =   Current Assets / Current Liabilities 

Our first liquidity ratio, Current Ratio, suggests how well a company has its current liabilities covered with cash or things that can be converted to cash quickly. In other words: how easily can they pay their current bills?

Quick Ratio =    (Current Assets - Inventories) / Current Liabilities
The Quick Ratio is often called the Acid Test. Since inventories are usually the least liquid of current assets, the Quick Ratio measures how well a company can pay its current bills without counting on liquidating inventory.

Some investors think of liquidity as lifeblood. After all, if a company can’t pay the bills due, it’ll quickly go out of business.

PROFITABILITY RATIOS 

I’m going to go through quite a few of these ratios without a lot of introduction. Their meaning will become clearer when we start applying them to CAT.

Profit margin on sales =     (Net income available to common stockholders) / Sales
Profit margins we’re all familiar with – this measures how much sales profit the company is delivering back to stockholders.

Basic earning power ratio (BEP)  =  EBIT / Total Assets

EBIT stands for Earnings Before Interest and Taxes and is itself an important measure. You’ll also hear about EBITDA, Earnings Before Interest, Taxes, Depreciation and Amortization.

ROA (Return on Assets)  =   (Profit margin)   X   (Total assets turnover)

Think of ROA and Total Assets Turnover as moving the merchandise.

Total Assets Turnover = Sales / (Totals assets)
ROE (Return on Equity) =     Net income / Common Equity
Dissecting CAT’s fall

Now for the exciting part: let’s apply these ratios to CAT. The historical table below (click here for a larger table) may not tell us much about what’s happening now, but it’s useful to look back in history to see how these things played out.

Current and Quick ratios are very low. I like these to be at least 2. When they get down to 1, that means CAT has barely enough current assets to covers its current liabilities. No more stocking up on extra paper clips and coffee filters or paying consultants on time; CAT’s liquidity looks very tight.

The average Current Ratio for S&P 500 stocks is 1.62, so if CAT’s 2008 figure is below that it could signal a problem. More on that in my next post, which will focus on CAT’s 2008 numbers.

Other than possible liquidity issues, CAT’s historical numbers look pretty good. I’ve plotted them below to make it easier to see trends. (Click here to see a larger Net Revenue graph).

Net Revenue has been steadily moving up but is slowing a little. Net profit was moving up very strongly, but in the last year it leveled off even though revenue went up. This may account for some of the leveling off of the stock price.

Below (click here for a larger Ratio graph) are some of the ratios plotted in the same manner along with P/E (Price/Earnings).

Early in this four-year period CAT saw nice growth in Operating Margin, but it flattened off. Gross Margins did the same and dropped, explaining why Net Income leveled off even with increased Top Line Revenue. This may indicate a cost of materials problem or a pricing problem. All of this can be good reasons for the stock price to stagnate.

P/E Ratio continues to drop. In 2003 it was 25; by 2007 it was 12. In other words, even though the stock price was going up dramatically, earnings were outpacing it. In effect, the stock was getting cheaper from an earnings perspective.

We’re narrowing in on some clues to CAT’s huge drop in 2008 – but we still need to do more investigating. Was CAT just a victim of this tough market, or were there fundamental reasons why it fell so hard? Next time we’ll look at the last four quarters and see if something dramatic pops up.

--Doc Maher

"Income Trader"

DocMaher Trading LLC

All-Star Commentator

Doc's previous posts: Understanding Cash Flow Statements and Time to Buy Ford LEAPS Calls?

Click here for a list of previous TradeKing All-Star blogs.

Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.

Jonathan F. Maher, PhD has a professional business relationship with TradeKing.