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Investment Analysis
Financial Ratios
Investment Analysis
Financial Ratios
Liquidity
Operating
You operate a business to turn a profit.
Operating performance ratios all have the words profit or turn in them.
Value
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 dont know
recognize fall under the fourth category.
Investment Analysis
Financial Ratios
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 Learnings 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:
Investment Analysis
Financial Ratios
Current assets
Current liabilities
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 dont 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.
Investment Analysis
Financial Ratios
Debt/Equity
Formula:
Debt/Equity
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
Investment Analysis
Financial Ratios
or
Note:
There are two ways to calculate this ratio. Both methods will result in the same
answer, but you must know both because you dont know what information they will
provide you with in the question.
Investment Analysis
Financial Ratios
Dividend Yield
Formula:
Dividend Yield
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 dont want you to forget them just because they are not specifically mentioned
in the financial ratios section.
Investment Analysis
Financial Ratios
Investment Analysis
Financial Ratios
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.
Investment Analysis
Financial Ratios
or
Inventory Turnover ratio
Note:
Net sales
Inventory
There are two ways to calculate this ratio. You need to know both because you dont
know what information they will provide you with in the question.
Investment Analysis
Financial Ratios
Dividend
1 - Tax rate
$ 600
$1,000
$1,400
$1,667