Document Sample
                 Don Gimpel’s Notes
                      Edited by Sandra Kovach

                  - QUESTIONS AND GUIDE TO ANSWERS -

1. Which is the single most important metric used to measure the investment
    quality of a company?
    See Cash Flow Indicator/Free Cash Flow.
2. What is the most conservative measure of liquidity?
    See Liquidity/Cash Ratio.
3. What is a good measure of management’s performance?
    See Profitability/Operating Profit Margin, OPM or Profitability/Net Profit Margin,
4. What is the key factor in gauging profitability?
    See Profitability/Return on Capital Employed, ROCE.
5. What is a good measure of a company’s ability to leverage debt?
    See Debt/Debt-Equity Ratio, DER.
6. What is a good measure of a company’s financial fitness?
    See Debt/Capitalization Ratio, CR.
7. What is the most conservative measure of a company’s funding ability?
    See Cash Flow Indicator/CCCR or CAPEX + Cash Dividends Ratio.
8. How can you tell if a company is able to keep paying high dividends?
    See the Cash Flow Indicator/Dividend Payout Ratio, the DPR.|
9. What’s the best measure of a company’s profitability?
    See Investment Valuation/Price to Cash Flow.
10. Are there problems in using the P/E Ratio?
    See comments in Investment Valuation/Price-Earnings Ratio
11. What is “The King of the (Investment) Value Factors.”
    See comments in Investment Valuation/Price-Sales Ratio

                                      QUICK GUIDE TO INVESTMENT ACCOUNTING RATIOS
                               These notes are based in part upon material found in

LIQUIDITY … A measure of a company’s ability to pay its short-term debts
Type/Measurement       What it means                         The ratio                                        Comments
Current Ratio, CR or   The proportion of current assets      CR = N / D                                       This method is flawed because a company
Current to Working     available to cover current            N = Cash or cash equivalents + marketable        is a going concern and its ability to cover
Cash Position          liabilities. The higher the ratio,    securities + receivables and inventory           it’s current debts is not really significant
                       the better                            D = Notes payable + current ST debt payables +
                                                             accrued expenses+ taxes
Quick Ratio, QR, or    This is a measure of the amount       QR = N / D                                       The most liquid assets available to cover
Quick Assets Ratio,    of the most liquid assets to          N = Cash & Equivalents + ST Inventory +          current liabilities. A more conservative
QAR                    cover current liabilities. The        Accounts Receivable                              valuation than the Current Ratio. The
                       higher the ratio the better.          D = Current Liabilities                          “quickness” of the ratio depends upon the
                                                             (1+3+2)/33                                       time required to collect receivables.

Cash Ratio, CashR      A refinement of the current           CashR = N / D                                    The most conservative liquidity measure. It
                       ratio to cover current liabilities.   N = Cash & Cash Equivalents + Invested Funds     is not realistic to have a CR>1 because it
                       The higher the ratio the better.      D = Current Liabilities                          might be considered poor asset utilization.
Cash Conversion       # Days a company’s cash is tied
Cycle, CCC            up in production and sales. The
                      shorter the better.
Note: The numbers in column 3 refer to Balance Sheet or P&L line items.

PROFITABILITY … A measure of a company’s valuation
Type/Measurement      What it means                    The ratio                                       Comments
Profit Margin, GPM    These four ratios measure a      GPM = Gross Profit / Net Sales                  GPM measures how efficiently a
Operating Profit      company’s ability to make              = ( 1 – Cost of Goods Sold / Net Sales)   company uses its raw materials, labor
M.,        OPM        money. The higher the ratio      16-COGS/16                                      and mfg.-related assets.
Pretax Profit         the better.                      OP = Gross Profit – Operating Expenses          Management has real control of OPM so
Margin, PPM                                            (16-COGS)-36                                    this is a good measure of performance.
Net Profit Margin,                                     OPM = OP / Net Sales                            PPM is similar to OPM.
NPM                                                          = (Gross Profit–Selling Exp.-GA ) / Net   NPM is the bottom line and a good
                                                       sales                                           performance measure..
                                                       PPM = Pretax Profit / Net Sales 17/16
                                                       NPM = Net Income / Net Sales 18/16
                                                       GA = General & Administrative Expenses
Effective Tax Rate,   Provides a good understanding    ETR = Income Tax Expenses / Pre Tax Income      Some analysts prefer to use the pretax
ETR                   of a company’s tax rate.         20/17                                           profit instead of the net profit number for
                                                                                                       the profitability.
Return on Assets,     This shows how profitable a      ROA = Net Income / Average Total Assets         This is best used for historical purposes
ROA                   company is compared to total     18/19 AVG                                       because businesses vary widely in their
                      assets. The higher the better.                                                   Fixed Asset requirements.
Return on Capital     This compliments the ROE by      ROCE = Net Income + Capital Employed            Factoring debt liability into the total capital
Employed,. ROCE       adding debt liabilities.         18+(11+12AVG)+8AVG                              provides a more comprehensive measure of
                                                       Capital Employed = Avg. Debt + Average          how well management is using debt. Focus
                                                       Shareholders Equity                             on ROCE as the key factor to gauge
                                                                                                       profitability. ROCE should be >= a
                                                                                                       company’s borrowing rate.

DEBT … A measure of how well a company is using outside assets in its operations.
Type/Measurement     What it means                     The ratio                                        Comments
Overview of Debt
Debt Ratio, DR       This measures the total debt to   DR = Total Liabilities / Total Assets            The Debt Ratio provides a quick take on a
                     total assets, a measure of a      7/6                                              company’s financial leverage.
                     company’s debt leverage. The
                     lower the better.
Debt-Equity Ratio,   This is another leverage ratio.   DER = Total Liabilities / Shareholders Equity    An easy-to-calculate ratio provides a
DER                  This measures how much            7/8                                              general indication of a company’s
                     suppliers, lenders, creditors                                                      equity-liability relationship. DER
                     and obligors have committed                                                        provides a more dramatic perspective on a
                     versus shareholders. The                                                           company’s leverage than DR.
                     lower the ratio.
Capitalization       This ratio provides a key         CapR = LT Debt/(LT Debt + Shareholders           This measures financial fitness. One of
Ratio, CapR          insight into a company’s use      Equity)                                          the more meaningful debt ratios.
                     of leverage. This is an           12((12+8)
                     excellent measure of
                     investment quality. The
                     lower the ratio the better.
Interest Coverage    This determines how easily a      EBIT – Earnings before Interest and Taxes        When ICR < 1.5, the company’s ability to
Ratio, ICR           company can pay interest on its   9                                                meet its interest expenses is questionable.
                     debts. The higher the ratio the   ICR = EBIT / Interest Expense
                     better.                           9/10
Cash Flow to Debt    This ratio provides an            Total Debt = ST + LT debt                        A high double-digit ratio is a sign of
Ratio, CFDR, or      indication of a company’s         11+12                                            financial strength. A low ratio indicates too
Free Cash Flow to    ability to cover its total debt   CFDR = Operating Cash Flow / Total Debt          much debt or weak cash flow generation.
Debt Ratio, FCFDR    with its yearly cash flow. The    Other = Redeemable Preferred Stock + 2/3 of
                     higher the ratio, the better.     principal of non-cancellable operating leases.
                                                       FCFDR = Operating Cash Flow/(Total Debt +

OPERATING PERFORMANCE … A broad measures of a company’s operating health
Type/Measurement  What it means                  The ratio                                                Comments
Fixed-Asset      This is a rough estimate of the FAT = Revenue / (Property + Plant + Equipment)           This measures a company’s efficiency in
Turnover, FAT    productivity of a company’s     14/15                                                    managing fixed assets. Best used with
                 fixed asset utilization. The                                                             historical ratios to establish trends. This
                 higher the ratio, the better.                                                            ratio is highly dependent on the company’s
                                                                                                          kind of business
Sales Revenue per     This a measure of personal       SRE = Revenue / # Employees                        Like others in this class, this measure is
Employee, SRE         productivity as Net Sales per        = Net Sales / # Employees                      highly dependent upon the nature of the
                      Employee                         14/#Employees                                      business. It is best used to determine
                                                       16/#Employees                                      trends among competitors.
Operating Cycle, OC   A measurement of management      OC = DIO + DSO – DPO                               The more efficient the collection
                      performance similar to the       DIO = # Days Inventory outstanding =               operations, the better. The slower the
                      CCC. The fewer the # days, the   Average Inventory divided by Cost of Sales/day     payables are paid, the better. The lower the
                      better.                          Average Inventory = (Io + Ie) / 2                  inventory to sales ratio, the better. When
                                                       Cost of Sales per day = Annual Cost of Sales/365   using the OC, look for historical
                      THINK OF THIS AS CASH                                                               consistency.
                      SENT OUT AND THE CASH            DSO = # Days Receivable’s Outstanding =
                      COLLECTED. MORE                  Average Accounts Receivable/Net Sales per day
                      IMPORTANT WITH THE               Avg. Acct. Rec = (Initial + Final)Acct. Rec. / 2
                      RETAIL SECTOR. LOOK              Net Sales / Day = Annual Net Sales / 365
                      FOR THIS INFORMATION
                      IN THE NOTES                     DPO = # Days Payables Outstanding =
                                                       Avg. Accts. Payable / Cost of Sales per day
                                                       Avg. Acct. Payable = (Init. + Final ) Payables/2
                                                       Cost of Sales/Day = Annual Cost of Sales / 365

CASH FLOW INDICATOR … A measure of how efficiently a company uses its cash assets
Type/Measurement      What it means                      The ratio                                       Comments
Operating Cash Flow   The Operating Cash Flow to         OCF/S = Operating Cash Flow / Sales             There are three sources of cash flow: (1)
to Sales Ratio,       Sales Ratio measures how the       OCF is taken from the Cash Flow Statement.      from operations, (2) from Investing and (3)
OCF/S                 cash generated from operations     Net Sales is taken from the Income Statement    from Financing. Use only the part derived
                      varies over time. Generally, the   13/16                                           from operations, which is usually the
                      greater the ratio, the better.                                                     foremost source of cash.
Free Cash Flow to     This is the fraction of cash       FCF/OCF=(1–Capital Exp./Operating Cash          Many investment institutions value Free
Operating Cash        flow available for expansion,      Flow)                                           Cash Flow ahead of earnings as the single
Flow, FCF/OCF         acquisitions and/or financial      1-(17/13)                                       most important financial metric used to
                      stability to enable a company                                                      measure the investment quality of a
                      to weather difficult                                                               company.
                      conditions. The higher the
                      ratio, the better.
Cash Flow             These are measures of the          STDC = OCF / ST Debt 13/11                      These ratios determine the company’s
Coverage Ratio,       ability of a company’s OCF to      CEC = OCF / Cap. Exp. 13/17                     funding ability. The last ratio is a really
CCCR                  meet its obligations. The          DC = OCF / Cash Dividends 13/21                 stringent measure that puts cash to the
                      higher the ratio the better.       CAPEX + Cash Dividends Ratio =                  ultimate test. It is “free cash flow on
                                                           OCF / (Cash Expenditures + Cash Dividends )   steroids” and indicates high investment
                                                         13/17+21                                        quality
Dividend Payout       Measures the fraction of           DPR = Dividends per Common Share                This ratio is only used for dividend
Ratio, DPR            earnings allocated for cash                Earnings per Share                      paying companies. Look for consistent
                      dividends. This is a measure       (21/24)/(18/24)                                 or steadily increasing ratios. Be
                      of how well earnings support                                                       skeptical of excessively high dividends
                      the dividend payment. The                                                          because the company might not be able
                      smaller the ratio the better.                                                      to keep it up triggering a sharp stock
                                                                                                         price decline.

INVESTMENT VALUATION … A measure of how an investment is valued
Type/Measurement       What it means                      The ratio                                           Comments
Per Share Data
Price to Book Value    This ratio is how many times a     PB = Stock Price / Shareholder’s Equity per share   When a company’s stock price is less than
Ratio, PB              company’s stock value is           23/(8/24)                                           it’s book value then (1) the stock is
                       trading per share compared to a                                                        undervalued and represents a buying value
                       company’s book value per share                                                         or (2) if that evaluation is correct, the
                                                                                                              investment will be perceived as a losing
                                                                                                              proposition or at best a stagnant investment
Price to Cash Flow     This ratio is used to evaluate     PCF = Stock price / Operating Cash Flow per         This ratio is similar to PB but many
Ratio, PCF             an investment’s                    share                                               analysts consider it more reliable for
                       attractiveness. The lower the      23/(13/24)                                          evaluating acceptability of current
                       ratio the better.                                                                      pricing because it is not as easily
Price to Earnings      This is the best known             PE = Stock Price / Earnings per share               This ratio is often optimistic during bull
Ratio, PE              investment valuation               23/(18/24)                                          markets and pessimistic during bear
                       indicator.                         Substitutions for the denominator include:          markets. It should be looked at
                                                          TTM = Trailing Twelve-month Earnings/Share          skeptically particularly if forward
                                                          Obtain from 25 Price/Sales Ratio                    earnings estimates are used. High P/Es
                                                          FEPS = Estimate future 12-month                     imply a growth company where potential
                                                          Earnings/Share Obtain from 22 Earnings per          investors are willing to pay extra for
                                                          Share Growth – Growth is an estimate                potential growth. This ratio is highly
                                                                                                              sensitive to changes in accounting

Price to Earnings to   The PEG Ratio is a refinement      PEG = PE / G                                        If the PEG = 1. the market is currently
Growth Ratio, PEG      of the PE Ratio made by            (23/(18/24))/22                                     valuing a stock in accordance with the
                       including the growth factor in     Here, G is the E/S Growth.                          stock’s current estimated earning per share
                       the denominator into the current                                                       growth. If the value is <L1, the stock is
                       valuation. It measures the         This is a variation of Graham-Dodds valuation       undervalued and if >1, overvalued. The
                       degree to which high PE’s and      equation P = aE*(1 + bG) rewritten to the form      PEG Ratio determines the degree of
                       growth are correlated.             + (P/E) / (a*(1 + bG ))                             reliability of the assumption that high
                                                                                                              prices and growth are related. It is
                                                          Graham and Dodd found that the constants a and b    common to encounter estimates of a
                                                          depend upon the company’s specific industrial       company’s future growth that are incorrect.
                                                          classification.                                     See Value Line’s reports that are available
                                                                                                              free at most public libraries.

Price to Sales Ratio,   A stock valuation indicator      P/S = Stock price per share / Net Sales per share   According to James O’Shaughghnessy
P/S                     similar to the P/E Ratio         23/(16/24)                                          author of “What Works on Wall Street,”
                        except it measures valuation                                                         this ratio is “The King of Value
                        against Annual Sales. The                                                            Factors.” It beats all others and does so
                        lower the ratio, the better.                                                         consistently.
Dividend Yield, DY      A measure of valuation as the    DY = Ann. Dividend/Share / Stock Price per Share    This measure depends on the nature of the
                        annual dividend per share        (21/24)/23                                          company’s business, whether it’s “value”
                        divided by the stock price per                                                       or “growth” oriented, earnings, cash-flow
                        share                                                                                and dividend policies. The value of this
                                                                                                             indicator depends on whether the investor
                                                                                                             favors value or growth.
Enterprise Value        This is the ratio of the         EVM = EV / EBITDA                                   The EVM is influenced by investor
Multiple, EVM, in       “enterprise value” by EBITDA.    EV = Market Capitalization + Debt + Minority        sentiment and market conditions. It
years                   It measures how long it would    Interest + Preferred Stock – Cash – Cash            measures the value of a company as a
                        take for an acquisition to pay   Equivalents.                                        going concern.
                        off its costs.                   EBITDA = Earnings before Interest, Taxes,
                                                         Depreciation and Amortization


                             - ABBREVIATIONS -
CAPEX Capital Expenditure Coverage            FCFDR   Free Cash Flow to Debt Ratio
CapR Capitalization Ratio                     FEPS    Forward (ex ante) Earnings per share
CashR Cash Ratio                              G       Earnings per share growth
CCC   Cash Conversion Cycle                   GPM     Gross Profit Margin
CFDR Cash Flow to Debt Ratio                  ICR     Interest Coverage Ratio
CR    Current Ratio                           NPM     Net Profit Margin
DC    Dividend Coverage                       OC      Operating Cycle, Days
DER   Debt-Equity Ratio                       OCF     Operating Cash Flow
DIO   # Days Inventory Outstanding            OCF/S   Operating Cash Flow to Sales
DPO   # Days Payables Outstanding             OPM     Operating Profit Margin
DPR   Dividend Payout Ratio                   PB      Price to Book Ratio
DR    Debt Ratio                              PCF     Price to Cash Flow Ratio
DSO   # Days Receivables Outstanding          PE      Price to Earnings Ratio
DY    Dividend Yield                          PEG     Price to Earnings Growth Ratio
EBIT Earnings Before Interest and Taxes       PPM     Pretax Profit Margin
EBITDA Earnings before Interest, Taxes,       QAR     Quick Assets Ratio
      Depreciation and Amortization           QR      Quick Ratio
EPS   Earnings (ex post) earnings per share   ROA     Return on Assets
ETR   Effective Tax Rate                      ROCE    Return on Capital Employed
EV    Enterprise Value                        S       Sales, Net
EVM Enterprise Value Multiple                 SRE     Net Sales per Employee
FAT   Fixed-Asset Turnover                    STDC    Short-term Debt Coverage
FCF   Free Cash Flow                          TTM     Trailing 12-Month (Earnings per share)
FCF/OCF Free Cash Flow to OCF Ratio

ITEM                                     LOCATION
Accounts Receivable                      Balance Sheet/Assets/Current Assets
Assets, Total                            Balance Sheet/Assets/Total Assets
Book Value                               Balance Sheet/Equity
Capital Employed                         Balance Sheet/Equity
Capital Expenditures                     Balance Sheet/Fixed Assets/Property
Cash                                     Balance Sheet/Current Assets/Cash
Cash, Dividends                          Income Statement/Footnotes/Dividends per share
Cash, Equivalents                        Balance Sheet/Assets/Current Assets/Cash & Cash Equivalents
Cash, Flow                               Cash Flow Statement
Cash, Free Cash                          Cash Flow Statement
Cash Flow, Operating                     Cash Flow Statement
Cost of Goods Sold                       Income Statement/Expenses/Total
Debt, Average                            Balance sheet/Liabilities and Equity/Long-Term Liabilities./LT
Debt, Current Short-Term                 Balance sheet/Liabilities/Current portion of bank loans
Debt, Long-Term                          Balance Sheet/Liabilities & Equity/LT/Bank Loans
Dividend Payout Ratio                    Income Statement/ Footnotes
Dividend Yield                           Income Statement/Footnotes
Earnings                                 Income Statement/Net Earnings
Earnings per Share Growth                Income Statement/Footnotes
Employees, number                        Personnel Records
Enterprise Value
Enterprise Value Multiple
Expense, Accrued                         Income Statement/Total Expenses
Expense, General & Administrative (GA)   Income Statement/Expenses/G&A
Expense, Income Tax                      Income Statement/Scheduled Expenses
Expense, Interest                        Income Statement/Scheduled Expenses
Expense, Operating                       Income Statement/Variable Expenses
Expense, Selling                         Income Statement/Variable Expenses
Income, Net                              Income Statement/Net Earnings
Income, Pre-Tax                          Income Statement/Net Earnings
Inventory                                Balance Sheet/Assets/Current Assets/Inventory
Invested Funds                           Income Statement/Operating Income/Interest Income
Liabilities, Current                     Balance Sheet/Liabilities & Equity/Current Liabilities/Total
Liabilities, Total                       Balance Sheet/Liabilities & Equity/Total Liabilities
Minority Interest
Notes payable                            Balance Sheet/Liabilities & Equity/Current Liabilities/Current
                                         Portion of Bank Loans
Preferred Stock, redeemable              Balance Sheet/Equity
Price to Sales Ratio                     Income Statement/Footnote
Property, Plant & Equipment              Balance Sheet/Assets/Fixed Assets/Property, Plant and Equipment
Profit, Gross                            Income Statement/Gross Profits
Profit, Pretax                           Income Statement/Profit
Receivables                              Balance Sheet/Assets & Equity/Current Assets/Acct. Receivable
Sales, Net                               Income Statement/Revenues/Sales Net
Securities, Marketable                   Balance Sheet/Assets/Current Assets/Cash & Cash Equivalents
Shareholders Equity, Average             Balance Sheet/Equity/Per share capital
Taxes Payable                            Balance Sheet/Liabilities and Equity/Current and Long Term
                                         Liabilities/Taxes Payable

   REVENUES                                      QUICK GUIDE REFERENCE
16    Net Operating Sales                        Net sales
      Other Income                               Interest Income
14    TOTAL REVENUE                              Total revenue

36   Operating Total                             Expenses, operating
37      Selling                                  Selling expense
38      G&A                                      General & Administrative Expense
     TOTAL EXPENSES                                  Total expenses

     EBITDA                                         Earnings before Interest, Taxes, Depreciation &

10    Interest
      Depreciation and Amortization
17             Pre-tax Profit                       Pre-tax Profit
20    Taxes

18     NET EARNINGS                                 Net Earnings

21      Cash dividends
24      Average # shares outstanding in period
23      Stock price at close of period
22      Earnings per share growth
25      Price/Sales Ratio

                                             CASH FLOW
      + Net Earnings
      + Depreciation and Amortization
      - Change in working capital
      - Funds Invested in Period

13        QUICK CASH FLOW                                Quick Cash Flow

     ASSETS                                     QUICK GUIDE REFERENCE

1       Cash & Cash equivalents            27    Cash & Cash Equivalents
2       Accounts Receivable                      Accounts Receivable, Receivables
3       Inventory
4       Prepaid expenses
5       Securities, marketable                   Securities, marketable
6       Other current assets

15       Property, Plant and Equipment     17    Capital expenditures (fixed asset
          Other intangible fixed assets

6         TOTAL ASSETS                     19    Total Assets


8       Accounts Payable
9       Current Income Taxes               34    Taxes payable
10      Current portion of bank loans      35    Notes payable
30      Short-term provisions
32      Other
33         Total Short-term Liabilities    11    Current short-term debt, Liabilities-current

      Bank loans
      Issued debt securities
      Deferred tax liability
26    Provisions – minority interest
7         Total Long-term Liabilities      12     Debt, long-term


        Per Share capital                  24    Shareholders equity per share
        Capital reserves
        Revaluation reserves
        Retained profits
        Preferred stock redeemable         15    Preferred stock redeemable

        Book value                               Book value