Georgetown Collegiate Investors

Risk Committee Educational Program. By Carlos Roa (CRO)

Education Session 3: Financial Ratios
Understanding the Fundamentals
Introduction
Comparables: Valuing a company based on its peer universe
Requires universally applicable metrics to control for company
size
Allows companies with different revenues, currencies, and
businesses to be compared statistically
Liquidity Ratios
Measure the ability of a company to pay off its liabilities (obligations to
creditors)
Higher ratios = better ability to pay off debts/sudden liquidity shocks
Current Ratio: Measures ability of company to cover all of this years
liabilities with liquid assets if they came due immediately.
Formula: Current Ratio = Current Assets / Current Liabilities
Current Ratio > 1 = Company can cover more than all of this years debt
obligations with this years liquid assets
If Current Ratio < 1, company has too little short-term liquidity; may indicate
problems with debt
BEWARE: An excessively high current ratio may indicate overstocked
inventory or too much outstanding accounts receivable (A/R)
Quick Ratio: Attempts to control for illiquid inventories (think Boeing and all
their planes & gear).
Formula: Quick Ratio = Current Assets Inventory / Current Liabilities
Leverage Ratios
Debt Ratio: (aka Debt/Value ratio, D/A, D/V)
Measures Debt (Leverage) as a % of Total Assets
Formula: Debt Ratio = Long Term Debt + Short Term Debt = Current
Portion of Long Term Debt / Total Assets
Whats the right amount: Depends
Leverage: works both ways
Less leverage = more financially stable, room for future financing
More leverage = greater returns on equity, greater risk of default
When in doubt, look at peer universe
General rule of thumb: less debt = better compared to peers
Leverage Ratios (Cont.)
Debt to Equity Ratio: (D/E)
Measurement of stockholders contributors to company borrowings
from creditors
Formula: Debt Equity Ratio = Total Liabilities / Total Shareholders
Equity
More commonly used in comparable analyses; both D/E and D/V
Capitalization Ratio:
Measures the actual debt competent of a companys capital structure
Formula: Capitalization Ratio = Long Term Debt / (Long Term Debt +
Shareholders Equity)
More refined than total liabilities, reflects only bank debt and bond
issuance
Profitability Ratios
Gross Profit / Revenue Ratio:
Used to analyze portion of sales used for raw materials, direct
labor costs and manufacturing-related fixed assets (relatively
uncontrollable costs)
Formula: Gross Profit = Sales (revenues) COGS (Cost of Goods
Sold)
Beware: some industries have little/no COGS
Profitability Ratios (Cont.)
Operating Profit Margin:
Formula: Operating Profit Margin = Operating Profit / Revenue
Profit after selling, general administrative expenses (SG&A) as a
percent of revenue
Measures profit after more controllable costs are taken out
these include management labor costs and supporting costs,
marketing and distribution costs, depreciation and amortization
Management can usually control these costs more and an
abnormally wide discrepancy between gross profit and operating
profit can point to needed changes in SG&A expense
Profitability Ratios (Cont.)
Net Profit Margin:
The X amount of of profit per dollar in sales. In other words, the Bottom
Line (Net Earnings). Its expressed as a percentage.
Formula: Net Profit Margin = Net Income / Sales
Return on Assets (ROA):
Tells how many dollars of earnings are derived from each dollar of
assets that are controlled. The higher the return, the more efficient
management is utilizing its asset base.
Formula: ROA = Net Income / Total Assets
Return on Equity (ROE):
Measures how much the shareholders earned for their investment in
the company.
Formula: ROE = Net Income / Total Equality
Note: ROA is typically lower than ROE; higher debt increases ROE
Cash Flow Ratios
Focus on the cash being generated and the safety net that it
provides to the company
Cash is needed by companies to undertake many activities that
investors expect such as: R&D, new investments, payment of
debt, payment of dividends, etc.
While a company may be profitable on paper, this says nothing
about whether those profits translate into the cash it needs
Numbers come from Statement of Cash Flows
Cash Flow Ratios (Cont.)
Free Cash Flow to Net Income = Free Cash Flow / Net Income
Free Cash Flow = Operating Cash Flow Capital Expenditures
(CapEx)
Free Cash Flow is sometimes considered more important than
earnings by analysts
Remove Capital Exchange because this is standard and essential
across businesses
Expressed as a percentage of net income because this shows
how profits are turned into Free Cash Flow
Because Net Income is the denominator, ratio can fluctuate by
quarter and should generally be used with annual numbers
Also possible to express FCF as a percent of Operating Cash Flow
Cash Flow Ratios (Cont.)
Cash Coverage Ratios:
Measure a companys ability to cover liabilities or pay costs using
operating cash flow; assumes all assets arent liquid
Formulas:
Operating Cash Flow (OCF) = Earnings Before Taxes & Interest (EBIT) +
Depreciation Tax

Short Term Coverage Ratio = OCF / Short Term Debt

CapEx Coverage Ratio = OCF / CapEx

Dividend Coverage Ratio = OCF / Cash Dividends Paid
Cash Flow Ratios
Dividend Payout Ratio:
Percentage of a companys earnings paid out as cash dividends
Formula: Dividend payout ratio = Dividend per share / Earnings
per Share (EPS)

Dividends paid out are listed under financing activities on the
Cash Flow Statement
Basic Valuation Ratios
Can be used by investors to estimate the attractiveness of a
potential or existing investment
Price to Book
Price to Earnings
Beta (Risk Assessment)
Valuation Ratios:
Price to Book Ratio (P/B) or Market to Book Ratio (M/B):
If a companys stock price (market value) is lower than its book
value, it can indicate one of two possibilities:
Unfairly or incorrectly undervalued
It is correct
Caveats
Intellectual property
More relevant for use by investors looking at capital-intensive or
finance-related businesses, such as banks

Valuation Ratios
Price to Earnings Ratio (PE or P/E):
Most widely used metric for stock valuation; excellent screening
tool
Gives an idea of how much an investor is willing to pay for every
dollar of earnings
Note: Earnings per share is based on accounting conventions related
to a determination of earnings that is susceptible to assumptions,
interpretations and management manipulation
Formula: PE = Price per share / Earnings per share (EPS)


PE Higher than Peers PE Lower than peers
Potential Undervalue Market notes companys
value over BV highly due to
good operations
Market is not accurately
appreciating the value of the
companys potential
Potential Overvalue Market is overpaying for $1
of earnings
Company has flaws making
its growth less valuable
Risk Ratios: Beta
Beta assesses the business and financial risk of a company
Assumes diversifiable risk is eliminated in a portfolio
Based on theory of volatility (risk)
Beta ranges from negative infinity to infinity, but is usually
between 0 and 2:
< 1 = Negative volatility; inverse to how the market moves
0 = No volatility; constant price
1 = Market volatility; moves in step with the market
2 = Twice as volatile

How to Use
Targeting Peer Groups
Direct comparisons with direct competitors
Industry: Retail, Media/Telecom, Energy, etc
Sector: Food Service, Retail Clothing, Communications
Sub-Sector: Fast Food, Catering, High-End Restaurants
Size & Product Profile: Sort by market cap (size), product
offering/geography
Market Cap: Measure of a companys size
Market Cap = Price of Stock * Number of shares outstanding