A Comparison of Ratios

The table below contains some recent ratios of three companies in the restaurant industry.  (Source:  Reuters)  The first few lines of the table show the company name, the ticker symbol, the headquarters' city, and the brand names owned by the company.  The ratios were compiled in April of 2009 and are used here to illustrate the larger subject of financial statement analysis.

A review of the ratios reveals the following about the companies:

Liquidity Ratios

All three companies have significantly lower ratios than the industry average.  This is not surprising, however, since this can be explained by two factors:

1. Stability of sales and cash flows:  Being industry leaders, their sales and cash flows are more stable than the smaller firms in the industry, thus they don't need as much cash on hand.  The purpose of liquidity is to make sure that you have enough money to pay your bills when they come due and to handle sudden changes in fortunes.  If you can predict your cash flows pretty accurately, you don't need to keep as much cash on hand.  And its easier to predict cash flows accurately if you have the stability and maturity as a result of being an industry leader.

2. Access to credit lines:  Being large companies, these three have easy access to the credit markets.  Most companies of this size will have lines of credit, so they have been pre-approved for any loans.  There is no need to keep large amounts of cash on hand if you can pick up the phone and have the bank transfer money into your bank account when it is needed.  (Technically, you would be "drawing down" the loan that was previously approved.)

Debt (or Leverage) Ratios

YUM! Brands is debt-free, while the other two companies have considerable debt.  In fact, both Brinker's and Darden Restaurants' lenders have invested more in the company that the stockholders have.  The important question here is, "Have the companies taken on more debt that they can repay?"

1. The LT Debt to Equity, for example, for both companies is over twice the industry average.  This is a red flag and an analyst should ask this question, "The average firm in the industry believes that it can only support a debt level that is half the level of these two companies.  What makes me believe that these two can support such a high debt load?"  YUM! Brands of course has the most flexibility in terms of borrowing money in the future due to its high debt capacity, while both Brinker and Darden are more limited..

2. Interest Coverage:  The Interest Coverage ratio measures the ability of the company to pay the principal and interest on the debt.  Darden appears to be safer since its Interest Coverage ratio is 7.48, indicating that its profits (EBIT) are over 7 times as much as is needed to pay the interest expense.  Brinker is currently losing money, and while profits are not the same as cash flow, its operations may not be generating enough money to pay the interest and principal. 

Turnover (or Activity) Ratios

1. Receivables Turnover is much higher than the industry average for all three companies, so there are no apparent problems with collecting accounts receivable.  (But this is largely a "cash" industry anyway with lows amounts of credit granted.)

2. Inventory Turnover varies widely among the three companies, with Brinker enjoying a huge advantage.  They are generating much more in sales per dollar invested in inventory than the other two companies.  Dividing the Inventory Turnover ratio in 365 days of a year reveals how long the inventory stays in the company before being sold - this would be 3.4 days (Brinker), 5.8 days (YUM!), and 19.6 days (Darden).  Part of these differences may be attributable to different accounting methods also.

3. The Asset Turnover ratios of all three firms greatly exceed the industry average.  All three companies appear to be using their assets to generate considerable sales.

 Profitability Ratios

1. Current results:  YUM! Brands is currently the most profitable of the three companies (by all three ratios that measure profits), Darden earns more than the average firm in the industry (and about the same as the average firm in the economy), and Brinker is currently unprofitable.

2. 5-year average:  The 5-year averages give us a little longer term view of the companies.  However, even on this basis, the ranking is the same - YUM! is the most profitable, then Darden, then Brinker.

The Remaining Ratios (A Selected Few)

Valuation Ratios

1. P/E Ratio:  As measured by the Price/Earnings Ratio, investors are slightly more optimistic about YUM! Brands' future growth than Darden Restaurants'.  (Brinker currently has no earnings, so a P/E ratio cannot be calculated for it.)  However, the P/E ratio also measures the premium that you have to pay for the company and, for a quality company like YUM, the premium is relatively small.  Notice that the industry average is currently 3.21, indicating that investors are not very optimistic about the restaurant industry's ability to keep profits growing.  (These ratios were compiled in the midst of a recession in 2009.)

2. Beta:  Beta measures the volatility of the stock price (with 1.0 being the average for all companies).  Brinker International's stock is considerable more volatile than its two competitors, which makes it a riskier investment.

Sales Growth Rates

If we look first at the 5-year growth rate, then the 1-year growth rate, then the 1-quarter growth rate, we can see that YUM! Brands has been able to maintain its growth better than the other two companies.  Comparing the 5-year rate to the 1-quarter rate, for example, YUM! Brands' growth rate has declined but not as much as its other two competitors.

Efficiency Ratios

Both measures of efficiency favor YUM! Brands by huge margins.  Is this because YUM trains or motivates its employees much more effectively that its competitors?  No, a much more likely explanation is that YUM operates in the fast food sector of the industry while Brinker and Darden operate sit-down, full-service restaurants.  People make take an hour or more to eat one meal at a full-service restaurant.  During this hour, a fast food restaurant can service dozens of diners through its drive-through window, not counting the customers who go inside the restaurant to eat.

Summary

So what does our ratio analysis of the three companies tell us?

1. Brinker International - At the time of the review, Brinker had the weakest financial position of the three.  Its sales and earnings were declining, was currently losing money, had the most volatile stock price, and had the highest financial leverage of the three.  (You do not want much financial leverage when sales and earnings are declining.)  On the plus side, its inventory turnover is impressive and its liquidity is the highest of the three.

2. YUM! Brands - At the time of the review, YUM had the strongest financial position.  It had no debt (an excellent position to have when sales are declining), the lowest volatility of its stock price, the highest profitability, and the strongest growth rates.

3. Darden Restaurants - At the time of the review, Darden had an adequate level of profitability, the highest receivables turnover, and was having no difficulty in meeting its debt service payments (although its high debt level is not an advantage when sales are declining).  Its financial strength and performance lies between its two competitors.