Financial Ratios

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Investment Analysis Financial Ratios

Company Analysis: The Financial Ratios You have just passed CSC® #1 and you are feeling pretty good about yourself, as well you should; that's a great accomplishment! Now you open CSC® Volume II and one of the first things you come across is all of the financial ratios. These can be very intimidating, but don't worry...SeeWhy Financial Learning is here to help! In our experience, you are not likely to have to actually calculate more than 2 or 3 financial ratios; in fact, you will probably use your calculator only 6 or 7 times at most on the entire exam. Much like CSC® #1, this is not a math test.

Financial Ratio Analysis There are several financial ratios that can be calculated and examined to help assess a company’s performance and financial health. It is important to note that one ratio on its own tells you very little. To understand this, consider an individual who earns $150,000 per year. That is a very attractive salary but does this necessarily mean he is in good financial shape? To answer that question, you would need to also look at his net worth, current liabilities, etc. The same holds true for a company. However, when several ratios are looked at together they begin to tell a story. Financial ratios can be divided into four categories. To remember the four categories just remember that there is a: List Of Various Ratios Liquidity Operating Value Risk analysis On the exam, you will be required to know which ratios fall under which category. For example, you could be asked a question like, "Which category does the inventory turnover ratio fall under?" Below is the list of ratios that are discussed in your text, including which broad category they fall under. For some of these ratios, this will be all you need to know about them (the category they fall under).

To be used in conjunction with the money back guaranteed CSC #2 Online Exam Preparation program available at www.SeeWhyLearning.com. ®



Liquidity • • •

Current ratio (also known as the working capital ratio) Quick ratio (also known as the acid test) Operating Cash Flow

Operating You operate a business to “turn a profit”. Operating performance ratios all have the words “profit” or “turn” in them. • • •

Profit margin ratios Return ratios Inventory turnover

Value • • • • •

Dividend payout ratio Earnings per share Dividend yield Price earnings ratio Enterprise multiple

Risk analysis All Deal with debt or an obligation of debt (interest) or preferred shares (dividends) • • • • • •

Asset coverage Percentage of capital ratios Debt / Equity Cash flow / total debt Interest coverage Preferred dividend coverage

Exam tip:

Memorize three of the four categories and assume that any you don’t know recognize fall under the fourth category.




The actual textbook discusses close to 30 different financial ratios. In dealing with these ratios, we encourage you to ask yourself, "Why did I buy this study guide?" While you obviously have an interest in learning the material, most students buy this guide because they want to pass the exam. This is where SeeWhy Financial Learning’s expertise is invaluable because we know what to focus on for the exam. Historically speaking, there are generally 4 - 6 six questions on the exam where you may have to calculate and/or comment on the financial ratios. We have narrowed the list of 30 ratios down to 10 "must know" ratios. If you know and understand the following ratios well, you will get most, if not all, of these marks, and you will have saved yourself a ton of study time. The ratios we recommend knowing are:

Current ratio (also known as the working capital ratio) Quick ratio (also known as acid test) Debt/Equity Dividend payout ratio Dividend yield Percentage of capital ratios (already discussed) Earnings per share (EPS) Price earnings (P/E) ratio (almost always tested) Inventory turnover ratio Pre-tax Cost of a Dividend

For each of these 10 ratios, we will: Summarize what the ratio is. Help you understand what exactly the ratio tells you. Give you hints as to how they might word a question on the exam, which will prompt you to use the appropriate ratio. Provide other things to know or advice for the exam.




Current Ratio and Quick Ratio Formula(s): Current ratio (working capital)

Quick ratio (Acid test)

=

=

Current assets Current liabilities

Current assets - Inventories Current liabilities

What these ratios tell you: Both of these ratios are measures of liquidity. In other words, they give you an idea of whether or not the company will be able to make its short-term (current) liability payments. What you will see in the exam question if they want you to use this formula: If they ask you to comment on a company’s liquidity and tell you to use the most stringent test, you would use the quick ratio. If they ask you to comment on a company’s liquidity and tell you to use the least stringent test, you would use the current ratio. Other things to know:

If a company has poor liquidity, it could mean that it will have trouble meeting its short-term financial obligations. On the other hand, too much liquidity could be a warning sign that the company is being poorly managed. If management has too much cash sitting idle (not being used) it provokes the following question: “Why don’t you have this cash actively employed in the business and earning us profits?” Current assets are assets that are either cash, or are likely to be converted to cash, within one year. Current liabilities are liabilities that are due and payable within one year.




Debt/Equity Formula: Debt/Equity

=

Total debt (Short-term + Long-term) Total equity (all 5-comonents of equity)

What this ratio tells you: This ratio tells you the proportion of borrowed funds relative to the amount of money that shareholders have invested into the company. Too high a Debt/Equity ratio could mean the company has borrowed excessively, which would increase the financial risk of the company. It would be similar to a person with very little net worth but a whole lot of debt. What you will see in the exam question if they want you to use this formula: Any questions on Debt/Equity will usually specifically ask you about the company’s debt in relationship to its equity. Other things to know: The hardest thing about calculating this formula is knowing what is considered debt and what is considered equity. Debt includes: • • • • •

Short-term loans (like bank advances) Long-term loans (like mortgages) Bonds and debentures outstanding Etc. Note: Debt does not include accounts payable!

Equity Includes: • Common share capital • Preferred share capital • Retained earnings • Foreign currency translation adjustment • Contributed surplus. Remember our memory aid: Companies Prefer Retaining Fantastic Coaches”




Dividend Payout Ratio Formula: Dividend Payout ratio

=

Dividend per common share Earnings per common share

or

Dividend Payout ratio

Note:

=

Total dividends paid to common shares Total common share earnings

There are two ways to calculate this ratio. Both methods will result in the same answer, but you must know both because you don’t know what information they will provide you with in the question.

What this ratio tells you: This ratio tells you what percentage of the common share earnings the company pays out as a common share dividend. The rest will be retained in the company to finance future growth. What you will see in the exam question if they want you to use this formula: If they give you information on a few different companies and ask you which is more generous in sharing its profits with shareholders, you will use the dividend payout ratio. Other things to know: If you are given the above question, be careful to not just answer the company that pays the biggest dividend. Instead, calculate which company paid the highest dividend in relationship to earnings. For example: ABC had $1.00 EPS and paid out a $1.00 dividend (ABC paid out 100% of earnings) DEF had $10.00 EPS and paid out a $2.00 dividend (DEF paid out only 20% of earnings)




Dividend Yield Formula: Dividend Yield

=

Common (or Preferred) share dividend Current market price of that share

What this ratio tells you: What percentage the dividend is of the current market value of the stock. A client looking for income would prefer a higher yielding stock. What you will see in the exam question if they want you to use this formula They will usually just ask you about the common or preferred share's dividend yield. Other things to know: This may seem like a new formula to you but it is basically the same as the current yield formula you learned in CSC® #1. The only difference is when calculating current yield, you used interest (because bonds pay interest) and with divided yield, you use the dividend (because shares pay dividends).

Percentage of Capital ratios

Formula: Invested capital attributable to ??????

=

?????? Invested capital

This formula was discussed in great length earlier in the chapter. We only mention them again here because we don’t want you to forget them just because they are not specifically mentioned in the financial ratios section.




Earnings per Common Share (EPS) Formula: EPS

=

Net earnings – Preferred dividends Number of common shares outstanding

What this ratio tells you: The earnings on a per share basis. What you will see in the exam question if they want you to use this formula They will ask usually just ask you for the earnings per common share or "EPS". Other things to know: We are deducting preferred dividends from the net earnings because the preferred share dividends must be paid to the preferred shareholders before the company is allowed to pay any dividends to the common shareholders.




Price Earnings (P/E) Ratio Formula: P/E

=

Price of common Share Earnings per common share

What this ratio tells you: This ratio tells you how much investors are paying per dollar of income that the company currently earns. What you will see in the exam question if they want you to use this formula • • •

If they ask you how “expensive” a stock is. If they ask you, for which company the market is paying the most for its earnings. If they ask you, for which stock does the market have the highest regard.

Other things to know: When asked any of the above three questions you NEVER look at the market price only. The price can be artificially increased or decreased by the company performing a stock split or stock consolidation without anything substantially changing with the company. For this reason, we must look at price in relation to earnings. For example: Which of the following stocks is the most “expensive”?

ABC has earnings of $1.00 per share and has a market price of $50. What is its P/E? P/E = 50X, calculated as follows: $50 / $1 = 50X DEF has earnings of $50 per share and a market price of $50 share. What is its P/E? P/E = 1X, calculated as follows: $50 / $50 = 1X This is an exaggerated example for learning purposes but clearly, ABC is a relatively expensive stock. You are paying $50 for every $1 the company earns as compared to DEF where you are only paying $1 for every $1 the company earns. IMPORTANT:

The P/E ratio is also called the P/E multiple, as in multiply. This is why you see P/E as a "X" -- it means "times", as in "50 times earnings". You are paying 50 times earnings for ABC stock.




Inventory Turnover Ratio Formula:

Inventory Turnover ratio

=

Cost of goods sold Inventory

or Inventory Turnover ratio Note:

=

Net sales Inventory

There are two ways to calculate this ratio. You need to know both because you don’t know what information they will provide you with in the question.

What this ratio tells you: This ratio tells you how many times per year a company “turns over” its inventory. For example, if a T-shirt store generally has $10,000 worth of inventory and sells $10,000 worth of t-shirts each month, they turn over their inventory once per month. What you will see in the exam question if they want you to use this formula They will give you information on two different companies and ask you which company does a better job of turning over its inventory. The company with the highest inventory turnover ratio (within reason) is the one that does a better job of turning over its inventory. Other things to know: Inventory turnover rates should only be compared to the inventory turnover rates of companies in the same industry. It would make little sense comparing the turnover rate of a hamburger joint to the turnover rate of a car dealership. Too low an inventory turnover rate could be a concern. It could mean: • the company has an unusually high portion of unsaleable products. E.g. A computer store that still has a bunch of old Commodore 64 computers sitting in inventory. • the company has over-bought inventory (their inventory is way to large). • the value of the inventory has been overstated. Too high an inventory turnover rate could also be concerning. It could mean: • the company has too small an inventory and are losing out on sales. E.g. if a donut shop only keeps 1 donut on the shelf at a time, each time somebody purchases a donut, they would have to make more. This would clearly result in lost sales. To be used in conjunction with the money back guaranteed CSC #2 Online Exam Preparation program available at www.SeeWhyLearning.com. ®



Pre-tax Cost of a Dividend Formula: Pre-tax Cost of a Dividend

=

Dividend 1 - Tax rate

What this ratio tells you: When a company pays a dividend, it is not a tax-deductible expense, it is a sharing of the profits. In other words, dividends are paid with after-tax dollars. This means to pay $1,000 in dividends, the company actually has to earn more than $1,000 so when it pays tax on the earnings, it still has enough left over to pay the $1,000 dividend. What you will see in the exam question if they want you to use this formula They will ask you what the pre-tax cost of a certain dividend is, given a stated tax rate. Other things to know: As you can see this chapter has many ratios to memorize. Using a process of elimination, you can get the following question right even if you don’t know the pre-tax cost of a dividend formula. For example: ABC Corp. is in a 40% tax bracket. What is the pre-tax cost of a $1,000 dividend? a) b) c) d)

$ 600 $1,000 $1,400 $1,667

Ask yourself the following questions: If a company earned $600 and lost 40% to taxes, it would have 60% left over. Is 60% of $600 enough to pay a $1,000 dividend? Of course not, “A” is not the answer. Do that for all four answers... a) b) c) d)

$ 600 x 60% = $360 (this is not enough!) $1,000 x 60% = $600 (this is not enough!) $1,400 x 60% = $840 (this is not enough!) $1,667 x 60% = $1,000 (this is enough! The answer is D!)

Thank you for you interest in SeeWhy Financial Learning. We sincerely hope that you will allow us to be a part of your CSC® success!


Financial Ratios

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