Structuring Ratio Analysis Using the Scott Formula

Introduction

Although we teach accounting students that financial reports can be used to help make investment decisions, the actual mechanism for first integrating the information in financial statements and then translating the information to a buy/hold/sell decision is often left as a black box. We teach students how to interpret a ratio and whether increases in a ratio are, ceteris paribus, good or bad. Yet which ratios are most important and how much weight should they be given? Students often do a good job in assessing individual ratios, but have difficulty integrating the ratios to assess the firm’s overall operating and financial strength, and the student is on even shakier ground in evaluating whether the market has the firm’s stock price right. There are different ways to illuminate this black box. Some analysts use rough rules of thumb, often in combination. For example, some analysts will look for firms that reach a minimum threshold for sales growth and ROE combined with a maximum threshold for an appropriate price relative such as price to earnings or price to book value of equity. Alternatively, one can teach students to take the existing statements as a starting point and combine this with other information to make comprehensive forecasts of either future abnormal earnings or free cash flows.

A useful and complementary intermediate position that provides an excellent basis for integrating ratios and a basis for assessing prices is to apply Professor William R. Scott’s formula that first partitions ROE into operating and leverage components, and then explains the operating component using turnover and profit margin. Thus ROE is broken into three major elements, efficiency of operations (turnover), profit margins, and leverage.

The focus on ROE is consistent with maximizing shareholder wealth. By beginning with ROE, the Scott formula allows one to naturally telescope out from ROE to capture most of the financial ratios that are traditionally covered in financial statement analysis. Through the lens of the Scott formula, each ratio’s importance can be assessed by its ultimate impact on the firm’s ROE, so that the metric of shareholder wealth determines the importance of a ratio. If one combines the Scott formula with current sales growth information, one will have captured the current status of the most critical elements of a full fledged comprehensive forecast of abnormal earnings.

Together with sales growth, the Scott formula analysis concisely captures the firms current operating and financial strengths and permits comparisons to peer firms or industry averages. One can then compare the appropriate price relative for the firm (price/earnings, price/equity, price/sales) to peer firms or industry averages. One can then search for firm that are ordinally out of sync. A firm with a strong operating and financial structure as indicated through the Scott formula analysis, but a low price relative compared to its peers, would appear to be a bargain, while a firm with a weak operating and financial structure, but a high price relative compared to its peers, would appear to be a over-priced.

Applying the Scott Formula:

The Scott formula usefully splits ROE into additive operating and leverage elements. To properly do this one must restructure the Balance Sheet to distinguish between operations and financing similar to the approach taken in weighted average cost of capital calculations, that is liabilities that arise from operations such as accounts payable or future income tax liability must be deducted from operating assets. Similarly, cash and marketable securities that are excess to operations should be removed from operating assets and netted against the financial liabilities to obtain net Financial Debt. So a restructured Balance Sheet might appear as shown in Figure 1.

Note that the balance is now shown as Operating Capital = Financial Capital, so we can simply refer to “capital”, since they are equal. Failure to restructure the Balance Sheet will not allow one to compare properly the operating return to the cost of borrowing.

The Scott formula with its additive operating and leverage elements would appear as shown in Figure 2, assuming only common equity (no preferred stock or minority interest).

Note how we can quickly compare the operating performance of any two firms, and assess whether a specific firm’s ROE comes from generating large volumes of sales from a relatively small capital investment (CT) or from generating high profit margins (ROS). The net leverage effect is an additive term that has two elements. The first simply compares the return on capital with the cost of borrowed debt (ROC – ROD) to ascertain whether the firm has gained or lost from leverage. The (D/E) term captures the conventional description of leverage and magnifies this gain or loss depending on whether the ROC is greater than or less than ROD, respectively.

Students can quickly assess whether a firm with a high ROE has obtained it the “hard way” through successful operations (ROC) or through a risky financing strategy (ROC modestly greater than ROD, but a very high D/E). To better understand the firm’s position, students can then evaluate sub-ratios from each of the major categories, turnover ratios (CT), profit margins (ROS), and leverage (D/E) as depicted below. Note how the Scott formula forms a basis for integrating most other financial ratios by linking them to ROE via capital turnover, profit margin, or leverage. For example if a firm’s capital turnover was weak, we could then assess the individual turnover ratios to see if they are holding excessive inventories, have an excessively generous credit policy, or have too much plant and equipment relative to their sales volume, or whether all three factors are equally important. Similarly, we can look at various profit margins or expenses relative to sales to better understand which expense items may be better or worse than average. Thus, in the class exercise described below, students would begin by understanding how operations and leverage contributed to their current ROE, then breakdown operations into efficiency and profit margins, and then select additional ratios to better understand each of the three major elements.

A Class Exercise:

I have found the following to be a good class exercise that captures the integrative and pricing advantages of applying the Scott formula. Select some firms at random or from a particular industry. Let students do the Scott formula analysis including measures of sales growth and then telescope into sub ratios for a more complete analysis as described more completely below.

Have the students rank order the firms in terms of which should have the “highest” value. One way of doing this that adjusts for size differences among firms, is to ask the students, without knowing the current price, if they were to be given shares of stock in each firm equivalent to $100 of each firm’s book equity divided by that firm’s total book equity, which would they choose?

I usually place students in groups, allow students to develop rankings overnight, and then enter each group’s rankings at the front of the class the next day. At this point, you can discuss similarities and differences in the rankings in terms of which ratios or factors influenced students the most. It is often useful to produce a composite ranking out of the group rankings and the ensuing discussion at this time. You can then present price to book equity or price to earnings ratios at the approximate date of the release of the financial statements (i.e. March 31 for December 31 year ends). These price relatives (I am skipping the caveats concerning the use of price relatives) would also be ranked and one could compare the ranks from the financial analysis with the ranks based on the preferred price relative.

The ranks of the various groups could be compared with the “real” ranks to see who is closest, although not necessarily the most correct. Additionally, the group ranks and the composite rank could be contrasted with the price relative ranks. One can then have a useful discussion concerning why the firms’ ranks from the financial analysis coincide, or not, with the ranks from the price relatives. Ostensibly, one should be inclined to buy stocks that the financial analysis ranked high but the price relatives ranked low, and sell the converse. One is presumably neutral toward properly ranked stocks, high (low) rank from financial analysis with a high (low) rank from the price relative. As a final piece of information, one can obtain the prices one year later and compare price movements and whether the buy/sell strategy indicated above would have been successful. One should control for general market movements if you do this. Again, a useful discussion can occur over what went right or wrong.

Thomas W. Scott
University of Alberta School of Business