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effect on the performance of the fund. Some research suggests that allocation among asset classes has more predictive power than the choice of individual holdings in determining portfolio return. Arguably, the skill of a successful investment manager resides in constructing the asset allocation, and separately the individual holdings, so as to outperform certain benchmarks (e.g., the peer group of competing funds, bond and stock indices)...
Long-term returns
It is important to look at the evidence on the long-term returns to different assets, and to holding period returns (the returns that accrue on average over different lengths of investment). For example, over very long holding periods (eg. 10+ years) in most countries, equities have generated higher returns than bonds, and bonds have generated higher returns than cash. According to financial theory, this is because equities are riskier (more volatile) than bonds which are themselves more risky than cash.
Diversification
Against the background of the asset allocation, fund managers consider the degree of diversification that makes sense for a given client (given its risk preferences) and construct a list of planned holdings accordingly. The list will indicate what percentage of the fund should be invested in each particular stock or bond. The theory of portfolio diversification was originated by Markowitz (and many others) and effective diversification requires management of the correlation between the asset returns and the liability returns, issues internal to the portfolio (individual holdings volatility), and cross-correlations between the returns.
Investment styles
There are a range of different styles of fund management that the institution can implement. For example, growth, value, market neutral, small capitalisation, indexed, etc. Each of these approaches has its distinctive features, adherents and, in any particular financial environment, distinctive risk characteristics. For example, there is evidence that growth styles (buying rapidly growing earnings) are especially effective when the companies able to generate such growth are scarce; conversely, when such growth is plentiful, then there is evidence that value styles tend to outperform the indices particularly successfully.
Performance measurement
Fund performance is the acid test of fund management, and in the institutional context accurate measurement is a necessity. For that purpose, institutions measure the performance of each fund (and usually for internal purposes components of each fund) under their management, and performance is also measured by external firms that specialize in performance measurement. The leading performance measurement firms (e.g. Frank Russell in the USA or BI-SAM[1] in Europe) compile aggregate industry data, e.g., showing how funds in general performed against given indices and peer groups over various time periods.
In a typical case (let us say an equity fund), then the calculation would be made (as far as the client is concerned) every quarter and would show a percentage change compared with the prior quarter (e.g., +4.6% total return in US dollars). This figure would be compared with other similar funds managed within the institution (for purposes of monitoring internal controls), with performance data for peer group funds, and with relevant indices (where available) or tailor-made performance benchmarks where appropriate. The specialist performance measurement firms calculate quartile and decile data and close attention would be paid to the (percentile) ranking of any fund.
Generally speaking, it is probably appropriate for an investment firm to persuade its clients to assess performance over longer periods (e.g., 3 to 5 years) to smooth out very short term fluctuations in performance and the influence of the business cycle. This can be difficult however and, industry wide, there is a serious preoccupation with short-term numbers and the effect on the relationship with clients (and resultant business risks for the institutions).
An enduring problem is whether to measure before-tax or after-tax performance. After-tax measurement represents the benefit to the investor, but investors' tax positions may vary. Before-tax measurement can be misleading, especially in regimens that tax realised capital gains (and not unrealised). It is thus possible that successful active managers (measured before tax) may produce miserable after-tax results. One possible solution is to report the after-tax position of some standard taxpayer.
Asset Turnover

= Revenue


Total Assets

Indicates the relationship between assets and revenue.

Things to remember
• Companies with low profit margins tend to have high asset turnover, those with high profit margins have low asset turnover - it indicates pricing strategy.

• This ratio is more useful for growth companies to check if in fact they are growing revenue in proportion to sales.

Asset Turnover Analysis:
This ratio is useful to determine the amount of sales that are generated from each dollar of assets. As noted above, companies with low profit margins tend to have high asset turnover, those with high profit margins have low asset turnover. Cory's Tequila Co.'s asset turnover seems to be relatively low, meaning that it makes a high profit margin on its products. For companies in the retail industry you would expect a very high turnover ratio - mainly because of cutthroat and competitive pricing.
Collection Ratio

= Accounts Receivable


(Revenue/365)

This indicates the average number of days it takes a company to collect unpaid invoices.


Things to remember
• A high ratio indicates that the company is having problems getting paid for services or products.
• The ratio is sometimes seasonally affected, rising during busy seasons and falling during the off-season. To account for this seasonality, the average accounts receivable ((beginning + ending accounts receivable)/2) could be used instead.


Collection Ratio Analysis:
This ratio could perhaps be renamed as the "Thug Ratio", it explains the average time it takes to receive payment on sales. The "Thugs" at Cory's Tequila Co. seem to be doing their job quite well, on average it takes 37 days for customers to clear their invoices. This is quite reasonable since most companies clear pay all of their bills on a monthly basis. If we were really picky we could redo this calculation using only credit sales since cash purchases are received immediately.

Inventory Turnover

= Cost of Goods Sold


Average or Current Period Inventory

An important and often overlooked ratio that indicates inventory levels.

Things to remember
• A low turnover is usually a bad sign because products tend to deteriorate as they sit in a warehouse.

• Companies selling perishable items have very high turnover.

• For more accurate inventory turnover figures, the average inventory figure, ((beginning inventory + ending inventory)/2), is used when computing inventory turnover. Average inventory accounts for any seasonality effects on the ratio.


Inventory Analysis
Cory's Tequila Co. inventory has gone up almost 100% since last year, this could mean nothing or something. There could be something fundamentally wrong, perhaps sales are slowing. A change of 100% is quite substantial and should be a cause for concern if sales are slowing. But if we look more closely at Cory's Tequila Co.'s sales it shows that product sales have increased almost 50% since last year. In other words the higher inventory could simply be a factor of higher demand.
Debt-Equity Ratio

= Total Liabilities


Shareholders Equity

Indicates what proportion of equity and debt that the company is using to finance its assets. Sometimes investors only use long term debt instead of total liabilities for a more stringent test.

Things to remember
• A ratio greater than one means assets are mainly financed with debt, less than one means equity provides a majority of the financing.

• If the ratio is high (financed more with debt) then the company is in a risky position - especially if interest rates are on the rise.

Share Capital Analysis
The shareholder's capital has risen quite a bit if you compare the balance sheet numbers versus the previous year. Again this could mean a number of things, there are a couple reasons that this could have happened. Perhaps they've made acquisitions which were partially paid for through the issue of stock, or maybe they took on additional share capital from another firm. Another possible reason is that they had to issue more shares because they were strapped for cash. For the most part a rise in share capital is better than a rise in debt, but too much of a rise could be cause for alarm.

The Debt/Equity ratio is certainly far from perfect! A low ratio of 0.26 means that the company is exposing itself to a large amount of equity. This is certainly better than a high ratio of 2 or more since this would expose the company to risk such as interest rate increases and creditor nervousness. One way to improve their situation would be to issue more debt and use the cash to buyback some of its outstanding shares. The problem with issuing more and more stock like Cory's Tequila Co. has done means that outstanding shares become diluted and existing investors receive a smaller ownership portion with each additional share issued.

Note: Some prefer to use only "interest bearing long term debt" instead of total liabilities to get a more precise calculation.

Interest Coverage
= EBITDA


Interest Expense

Indicates what portion of debt interest is covered by a company's cash flow situation.

Things to remember
• A ratio under 1 means that the company is having problems generating enough cash flow to pay its interest expenses.

• Ideally you want the ratio to be over 1.5.

Interest Coverage Analysis:
If you will notice, Cory's Tequila Co. doesn't have any long term debt - therefore you will not find an interest expense. What a great position to be in, practically debt free. Companies with a ratio below 1 could run into serious trouble servicing its loan payments and are considered to be a high risk of defaulting. Because Cory's Tequila Co. has no interest expense its interest coverage ratio is infinite...obviously the best you could possibly have.

Working Capital Ratio (Current Ratio)

= Current Assets


Current Liabilities

Indicates if a firm has enough short-term assets to cover its immediate liabilities.

Things to remember
• If the ratio is less than one then they have negative working capital.

• A high working capital ratio isn't always a good thing, it could indicate that they have too much inventory or they are not investing their excess cash.

This ratio indicates whether a company has enough short term assets to cover its short term debt. Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient, Cory's Tequila Co. seems to be comfortably in this area.

If you wanted to take this ratio a step further then you could try the Acid Test/Quick Ratio - it is a more strenuous version of the W/C, indicating whether liabilities could be paid without selling inventory.


Ratio Analysis: Conclusion

There is a lot to be said for valuing a company, it is no easy task. I hope that we have helped shed some light on this topic, and that you will use this information to make educated investment decisions. If you have any other questions about fundamental analysis please don't hesitate to contact us.

Let's recap what we've learned:
• Financial reports are published quarterly and annually.
• Ratios on their own don't really tell us a whole lot, but when we compare them against previous years numbers, other companies, industry averages, or the economy in general it can reveal a lot!
• Every ratio has it's variations, some people exclude things that others include. Use what you feel comfortable with, but be sure to have consistency when comparing against other companies.
Also:
1. If you think we missed something and have