What financial ratios are best to evaluate for consumer packaged goods?

Companies that sell consumer packaged goods (CPGs) are traditionally high-margin, high-volume businesses. They produce goods primarily in the consumer staples category, with streamlined production facilities that can take advantage of economies of scale and lower overall costs of goods sold (COGS). The consumer packaged goods industry is highly competitive due to higher barriers to entry as well as high saturation and low consumer switching costs.

In the S&P 100, these companies include:

• Procter & Gamble (PG) household and personal products
• Coca-Cola (KO) non-alcoholic beverages
• PepsiCo (PEP) non-alcoholic beverages
• Philip Morris International (PM) tobacco
• Mondelez International (MDLZ) confectioners
• Altria (MO) tobacco
• Colgate-Palmolive (CL) household and personal products
• Kraft Heinz (KHC) packaged foods

Taking a broad look at these companies will usually best involve an analysis of basic ratios that are comprehensively important for all companies as well as some more unique to the industry group itself.

The Basics

There are a few key ratios to look for from the financials of any company you might be interested in investing in.

Return on equity (ROE): Return on equity can generally be the most comprehensive report on a company’s performance. ROE comes from dividing net income/shareholders’ equity.

Profit margins: You will want to take a look at profit margins on the income statement. The income statement can be broken down to show gross profit marginoperating profit margin, and net profit margin. Gross margin helps to assess COGS. Operating margin helps to assess what the company is spending on outside of goods for production. Net margin will factor in the company’s capital expenses as well as taxes. Profit margins for CPGs can be uniquely high, so this is something to look at a little more closely within the group.

Solvency: Solvency can be important to help understand a company’s debt liability loads. The interest coverage ratio shows operating expenses/interest expenses. Debt to equity is also typically used here. Another interesting ratio from the balance sheet is total liabilities/equity.

Working capital: Working capital will give an idea of the short-term capital the company has to meet its short-term needs. Working capital is calculated by taking current assets minus current liabilities. Oftentimes companies will set a working capital requirement to help accountants track this metric on a more regular basis. The net change in working capital from one reporting period to the next is also reported on the cash flow statement.

The Specifics

As mentioned, profit margins are always a key part of income statement analysis, but profit margins in CPGs can be unique. Profit margins are generally high in the CPG group. This is because many CPG companies have developed streamlined production facilities with the advantage of economies of scale to lower the overall cost of goods sold and create a higher gross profit margin. Thus, any low profit margin outliers in CPG can raise questions.

Below are profit margins for the eight largest CPGs in the S&P 100 as of March 2020.

Source: MarketWatch Profiles

Since there can be high competition, consumer packaged goods companies do often compete on price, which can affect margins. If operating margins are extremely low it can mean companies are overspending on operating expenses, which may not be paying off or could have a longer-term benefit. Lower relative net margins could be another problem if companies are relying on expensive capital for funding.

Beyond profit margins, activity ratios can also be important in the consumer packaged goods industry. These companies are wholesalers with many clients. This leads to a high level of importance on accounts receivable management as well as inventory management.

Accounts Receivable

Accounts receivable turnover: Calculated by taking net credit sales for a period over the average accounts receivable for the period. Higher turnover is better.

Accounts receivable days: Calculated by (accounts receivable for the period/revenue for the period) x number of days in the period. This ratio shows how quickly accounts are actually being paid in days (the average number of days it takes customers to pay their invoiced bill).

Inventory

Inventory is another key area that is important for CPGs. Operationally, inventory must be produced, stored, and distributed. For managers of inventory, two key ratios will also look at turnover and days.

Inventory turnover: COGS for a period / average inventory for the period. Inventory turnover and production levels can often be closely tracked and integrated for CPG companies. Higher inventory turnover means inventory is being sold and distributed faster. Higher inventory turnover can therefore lead to more production needs.

Inventory days: (Average inventory for a period / COGS for a period) x number of days in the period. This shows the number of days inventory is staying in storage after production.

Watching Activity Ratios

Overall, these four activity ratios can be very important for consumer packaged goods companies. These companies typically invoice with credit extended due to the nature of wholesaler and retailer relationships, so accounts receivable management is relevant and important. Inventory is also a big part of the business operationally, so tracking how inventory is moving can be very important to production levels and business flow.