Analyzing Ratios and Financial Statements

Fannie Mae and Uber

Executive Summary

Financial statements are commonly analyzed using ratios and this practice is highly beneficial to lenders and investors. The financial statements can be distilled into sets of comparative ratios which provide uses with a practical means of assessing a variety of financial data. Most often these ratios are used to determine a company’s risk for lending or investment. While financial ratios provide a great deal of benefit to financial users, they also have some inherent limitations. In the following report, the current, debt, ROE, and ROA ratios are discussed in terms of their benefits and limits. This report provides real world examples using Fannie Mae and Uber to show the limitations of the ratios based on timing and risk in accordance with market and economic forces.

This report shows the need to utilize multiple ratios to glean as much information as possible. Along with using multiple ratios, this research reflects the need to account for other forces that may be impacting ratios or causing them to be misleading. These forces can be internal as well as external such as management strategy which impacts ratios through spending.

Ration and Financial Statement Analysis

Financial ratios are a vital tool used in the analysis of financial statements by experts, investors, accountants, and researchers. These tools are commonly used in financial reporting. There use, while revealing, are definitively a numerical representation which, “expresses the mathematical relationship between one quantity and another” (Horngren, Sundem Stratton, Burgstahler, & Schatzberg, 2012). The importance of this definition reveals itself in its application. The relationship of quantities is informative but they are also interpretive which makes them tools requiring attention to many details that exceed the ratio. For example, financial statements are most often analyzed using the current ratio, debt ratio, and return on assets (ROA) (Horngren, Sundem Stratton, Burgstahler, & Schatzberg, 2012). These ratios beneficially explain financial statements and serve to benchmark a company’s performance in relation to other similar firms or competitors. However, these same ratios can be misleading when they are considered in a black and white manner without consideration of other subjective points such as market or economic factors.

Benefits of Ratio Analysis

Ratio analysis is used for predicting performance as in the case of stock returns and return on assets (Horngren, Sundem Stratton, Burgstahler, & Schatzberg, 2012). These ratios are also use in for determining lending viability between firms and lenders. Most important in these uses of financial ratios is their ability to control or limit firm activities. For example, a lender may require in a loan contract that the firm borrowing needs to maintain a current ratio of at least 2:1 which is considered appropriate in most industries (Faello, 2015). These forms of restriction ensure that the borrower restricts activities that may devalue the firm (Faello, 2015). As such the borrowing firm must manage current assets and current liabilities effectively.

From the standpoint of investors and lenders, financial ratios provide a history as well as a current and future performance. When analyzed, a negative trend in ratios provides the basis for determining whether a firm is failing or growing. Often these are ratios are used to measure the strength of the company in terms its capability to meet its debts (Faello, 2015). The current ratio is useful in this function as it measures a company’s ability to meet its liability payments for the course of the next year. The standard current ratio is 2:1 which dictates that a will functioning company will have twice as many assets as liabilities (Faello, 2015). This is generally considered a good sign that the company can pay its liabilities by selling its assets if it runs into trouble.

There are a number of related ratios to the current ratio. Another related ratio is the debt ratio which is used to determine a company’s ability to repay commercial bank loans (Faello, 2015). This ratio determines the percentage of company assets included in its liability.

When the current ratio and debt ratio are compared this provides a comprehensive view of the actual ability of the company to pay debt as well as a more accurate company value. Ideally, these ratios should be considered in relation to profit ratios which provide company’s ability to earn profit and return on investment. Profit ratios are generally considered strong indicators of a company’s financial health and the effectiveness of asset management.

The ROA ratio is the comparison of net income to total assets which provides the after interest and taxes view of income efficiency.

In conjunction with ROA, Return on Common Equity (ROE) is the ratio comparing net income after taxes with common equity. This ratio shows the stockholder’s return on investment. ROE reflects the company’s efficiency using owner capital or the percentage of return on owner investment.

Any interested party reviewing financial statements might consider a firm as a good investment providing it has a 2:1 current ratio, strong debt ratio, as well as showing a ROA along with a ROE, and in most cases this might be a solid assumption. However, there are inherent limitations in these ratios that must be understood in order to make appropriate financial decisions.

Limitations of Ratio Analysis

Ratios may be strong indicators but they are not always precise and they present the issue of revealing data that is not always practical. Impreciseness and practicality are married and present a serious problem for investors and lenders examining financial statements. This problem inherent in ratios is time. Current ratio and debt ratios take into account short-term or current values which can be misleading over the long term. For example, long term debts such as bond payouts or loans are not calculated in these ratios the absence of this data provides a distorted view of the financials.

Perhaps the largest limitation with current ratio is that of lack of information pertaining to market or economic conditions. A company having adequate assets to cover liabilities does not guarantee the company will be able to cover its debts. If a company’s assets are largely based on current inventory, then covering debt would require selling off the inventory. In an economic downturn, the ability to sell inventory may be slow or not possible without severe discounting. As such the current ratio and debt ratio are subject to market conditions and economic conditions making their values subjective to some degree.

One of the most powerful examples of this problem of external market and economic forces can be seen in the fall of Fannie Mae. In 1999, the large mortgage lender reduced standards on lending in order to increase homeownership (Acharya & Richardson, 2011). The result of this action was a massive increase in assets by virtue of more lending. The current ratio for Fannie Mae at the beginning of 2007 was more than 2:1 but by last quarter of the year the asset values collapsed as the housing market lost value (Acharya & Richardson, 2011). “Fannie Mae also reported a decrease in the non-GAAP estimated fair value of its net assets, from $35.8 billion as of December 31, 2007 to $12.5 billion as of June 30” (Fannie Mae, 2007).

Assessing ratios in terms of profit also presents difficulties. When judging financial performance, ROE has three significant limitations including timing, risk, and value determinations (Lesáková, 2007). Timing issues are common as in the case that businesses must sacrifice present earnings in order to achieve future earnings. There are times when normal costs can produce a low ROE such as during a startup of a new division or product (Lesáková, 2007). This is a failure in the ratio to account for long-term decision making that likely benefits the company making it a good investment.

Another issue is risk. ROE does not take into account the risk involved in company spending and this may lead to poor decision making (Lesáková, 2007). Tech companies are prime examples of this issue as they operate on rapid startup and deployment.

Uber’s ROE is lower than 86% of software companies and this is because Uber places market share and growth above profit (GuruFocus, 2020). This strategy lacks profit, but it is a common tech market strategy that propelled companies such as Amazon to success (Barro, 2020). However, looking solely at ROE would cause one to avoid this company.

Risk ties in with ROA. If there is not profit then there is no ROA or a negative (Faello, 2015). This again is misleading if the company is operating as Uber with a long-term strategy or is a undergoing a large capital investment for a project (Barro, 2020). This connection between profit linking ROE and ROA illustrates the need to take into account many factors beyond ratios as well as the use of many different ratios to make financial decisions.

Conclusions & Recommendations

Ratios inform and predict but most important, they provide clues to underlying conditions that may not be apparent in the individual financial statements. As identified in the aforementioned ratios, there are inherent limitations which necessitate the use of many different ratios to glean as much information as possible. The use of many ratios must also be considered in terms of economic and market forces. Looking only at financials provides a limited view of the company especially in terms of overlooking trends and strategies as shown in the Uber example. Perhaps the most important use of the financial ratios is found in the determination of obvious dangers which works well for short term investors but the value investor or lender will need to dig deeper into the ratios and other forces impacting the company.

References

Acharya, V. V., & Richardson, M. (2011). Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance. New Jersey: Princeton University Press.

Barro, J. (2020, August 10). If Uber’s Food-Delivery Business Isn’t Profitable Now, When Can It Be? Retrieved from New York Intelligencer: https://nymag.com/intelligencer/2020/08/if-uber-eats-isnt-profitable-now-when-can-it-be.html#:~:text=Uber%20and%20its%20competitors%20have%20often%20shown%20apparent,then%20it%20will%20be%20possible%20to%20raise%20prices.

Faello, J. (2015). UNDERSTANDING THE LIMITATIONS OF FINANCIAL RATIOS. ACADEMY OF ACCOUNTING AND FINANCIAL STUDIES JOURNAL, 19(3), 75–86.

Fannie Mae. (2007). FannieMae Reports Second Quarter 2008 Results. Retrieved from Fannie Mae: https://capmrkt.fanniemae.com/resources/file/ir/pdf/quarterly-annual-results/2008/q22008_release.pdf

GuruFocus. (2020, June). Uber Technologies ROE %. Retrieved from GURU Focus: https://www.gurufocus.com/term/ROE/NYSE:UBER/ROE-/Uber-Technologies#:~:text=Uber%20Technologies%20%28NYSE%3AUBER%29%20ROE%20%25%20Explanation%20ROE%20%25,known%20as%20net%20assets%20or%20assets%20minus%20liabilities%29.

Horngren, C. T., Sundem Stratton, G. L., Burgstahler, W. O., & Schatzberg, J. (2012). Introduction to Management Accounting. New Jersey: Prentice Hall.

Lesáková, Ľ. (2007). Uses and Limitations of Profitability Ratio Analysis in Managerial Practice. Budapest, Hungary: International Conference on Management, Enterprise and Benchmarking.