Financial ratios
This chapter is a direct copy of what you already learned in the fundamental analysis chapter. This should serve as a review.
There are various ways an investor can analyze a security to determine if it’s worthy of an investment. Generally speaking, there are two big categories of analysis: fundamental analysis and technical analysis.
Fundamental analysis is a traditional approach to analysis that pays close attention to a company’s revenues, expenses, debt levels, and product and/or service lines. Publicly traded companies are required to disclose their financials on a quarterly basis, which is where analysts gather this information. Stockholders have the right to inspect the books and records of a company, which is fulfilled through these financial disclosures:
10-K annual report
- Audited financial report
- Example: Tesla 10K filing
10-Q quarterly report
- Unaudited financial report
- Example: Microsoft 10Q filing
In these reports, fundamental analysts comb through financial documents to determine a company’s value. The most commonly analyzed documents are:
Balance sheet
- Compares assets and liabilities
- Assets - liabilities = net worth
Income (cash flow) statements
- Displays income and expenses
There are small differences between income statements and cash flow statements, but the exam generally does not cover them. Keep it simple and assume both provide the same information.
Balance sheets
Sometimes it’s easier to understand these financial documents when we think about them in personal terms. You could create a personal balance sheet if you documented all of your assets (things you own) and liabilities (things you owe), which would provide your own personal net worth. For example:
| Assets | Liabilities | Net worth |
|---|---|---|
| $250k home | $200k mortgage | |
| $20k car | $10k car loan | |
| $5k cash | ||
| $275k | $210k | $65k |
This is a simple personal balance sheet. This person has $275,000 of assets, $210,000 of liabilities, which leaves them with $65,000 of net worth. Companies account for assets and liabilities similarly (although it’s much more complicated), which leads analysts to a company’s overall value.
Corporate balance sheets are more complicated but are fundamentally the same as personal balance sheets. You won’t need to be an accounting expert for the exam, but it’s important to feel comfortable with the basics of a corporate balance sheet. Here’s a quick example of one:
Assets
Current assets = $125,000
- Cash and cash equivalents - $100,000
- Accounts receivable - $15,000
- Inventory - $10,000
Fixed assets = $350,000
- Real estate - $150,000
- Equipment - $80,000
- Land - $120,000
Intangible assets = $50,000
- Copyrights - $30,000
- Patents - $20,000
Liabilities & shareholder’s equity
Current liabilities = $100,000
- Accounts payable = $40,000
- Wages payable = $30,000
- Taxes payable = $20,000
- Interest payable = $10,000
Long-term liabilities = $150,000
- Debentures = $100,000
- Mortgage bonds = $50,000
Stockholder’s equity = $275,000
- Preferred stock = $80,000
- Common stock = $150,000
- Capital in excess of par = $25,000
- Retained earnings = $20,000
It might seem complicated, but remember you only need to know the basics. There are a few specific balance sheet items to be aware of:
Current assets and liabilities
The term “current” translates to “short term.” Current assets are either currently cash or can be reasonably turned into cash within a year, which include cash, cash equivalents (like a money market fund, accounts receivable (money owed to the company within one year), and inventory. Current liabilities are either currently due or must be paid off within one year, which include items with the term ‘payable’ in them. Payable refers to a payment the company must make in a short period of time.
Fixed assets
These are long-term tangible assets, which typically include real estate, property, vehicles, and equipment.
Intangible assets
These are long-term intangible (non-physical) assets, which typically include trademarks, patents, copyrights, and other forms of intellectual property.
Long-term liabilities
The name gives away this category. Long-term liabilities typically include loans that last longer than a year, bonds, and mortgages.
Stockholder’s equity
Equity relates to ownership. Stockholder’s equity typically includes outstanding stock, capital in excess of par and retained earnings. Capital in excess of par is the amount paid above the par value for an investment. For example, let’s assume an issuer sells $100 par preferred stock for $102 per share. The stock sale would credit $2 to capital in excess of par for every share sold. Retained earnings is the amount of earnings not distributed to stockholders. If a company makes $100,000 of earnings and distributes $80,000 to common and preferred stockholders, they’ll credit $20,000 to retained earnings*.
*The $20,000 of retained earnings in this example would be added to any unspent retained earnings accumulated over previous years.
Balance sheets ultimately provide net worth, also known as stockholder’s equity, which helps determine the overall value of a company. The formula is:
Can you calculate the net worth using the total assets and liabilities above?
It takes a little math, but it’s not a complicated formula. Add up all the assets and liabilities, then find the difference.
Balance sheet formulas
Let’s discuss the various formulas derived from the balance sheet that utilize current assets and liabilities in order to determine a company’s liquidity (access to cash).
Current assets and liabilities
Current assets typically include cash, cash equivalents (like money markets), accounts receivable, and inventory. Accounts receivable are payments for goods or services the company expects to receive shortly. Basically, if a company has cash or something that can reasonably turned into cash shortly, it’s considered a current asset. These are the items listed as current assets from the example in the previous section:
Current assets = $125,000
- Cash and cash equivalents - $100,000
- Accounts receivable - $15,000
- Inventory - $10,000
Current liabilities typically include accounts payable, wages payable, taxes payable, and interest payable. All of these relate to bills the company must pay within a short period of time. These expenses relate to the cost of goods, operation costs (general business costs), interest costs on outstanding loans (including bonds), and paying taxes. Basically, if something needs to be paid for within a year, it’s considered a current liability. These are the items listed as current liabilities from the example in the previous section:
Current liabilities = $100,000
- Accounts payable = $40,000
- Wages payable = $30,000
- Taxes payable = $20,000
- Interest payable = $10,000
Current ratio
The current ratio compares current assets and current liabilities. Companies use this ratio to determine their ability to handle short-term obligations. From a personal perspective, the current ratio would tell you if you could pay off a large bill if it came unexpectedly. If you can, great! If not, you’ll need to consider borrowing some money.
Corporations think the same way. How equipped are they if a large expense comes out of nowhere? The current ratio helps tell that story. This is the formula:
Using the example above, can you calculate the current ratio?
If you were to think about the numbers, it’s always better to have more assets than liabilities. If the current ratio is above 1, the company has more short-term assets than liabilities. If it’s less than 1, the company does not have enough short-term assets to cover its short-term liabilities. This isn’t ideal!
Net working capital
There’s another formula that involves current assets and liabilities. Net working capital doesn’t involve a ratio, but instead provides a specific amount of net assets or liabilities. Here’s the formula:
Using the same numbers as we did above, can you calculate the net working capital?
Instead of providing a ratio, we get a tangible number. If this company were to face an unexpected liability, it would have $25,000 of short-term assets that would help them pay for it.
Quick formulas
The term ‘quick’ refers to short-term finances. Each of the quick formulas in this section aims to measure the liquidity of a company. The more liquid a company is, the more cash and marketable assets they have on hand. When an unexpected payout is due, liquidity is important.
First, we’ll look at the quick assets formula:
By taking out inventory, the company is only focusing on cash and its marketable assets. If the company is forced to make a sudden, unexpected payout, its inventory probably won’t help (unless it’s very easy to sell its product). The quick assets formula is like looking in the wallet of a company.
There’s also a quick ratio, which is also known as the acid test ratio. This ratio is one of the best ways to determine the liquidity of the corporation because it factors in short-term liabilities as well.
The higher the quick (acid test) ratio, the more liquid a company’s finances are. If the ratio is above 1, the company has enough short-term assets without including inventory to pay off its short-term liabilities. If it’s lower than 1, the company may sell some of its inventory to pay its short-term obligations.
Income statements
Let’s switch gears and look at an income statement. If you’ve ever inspected your bank account, you’ve seen your own version of one. Income statements focus on the inflow and outflow of money. For example:
| Event | Amount |
|---|---|
| Paycheck from job | $3,000 |
| Groceries | -$100 |
| Mortgage payment | -$1,500 |
| Total | +$1,400 |
This is a simple personal income statement. After three events, this person has $1,400 of positive cash flow. Companies compile and disclose cash flow in a similar way, with many more line items. Analyzing income statements provides data on a company’s revenues and expenses, which help determine how well a company is selling its products & services and spending its money.
Similar to a balance sheet, the corporate version of an income statement is more complicated. Here’s an example of one:
| Line item | Amount |
|---|---|
| Sales revenue | +$200,000 |
| Cost of goods sold (COGS) | -$80,000 |
| Gross profit | $120,000 |
| Operating expenses | -$30,000 |
| Income from operations (EBIT)* | $90,000 |
| Interest (bonds & loans) | -$25,000 |
| Income before taxes (EBT)* | $65,000 |
| Taxes | -$10,000 |
| Net income | $55,000 |
| Dividends paid | -$20,000 |
| Retained earnings | $35,000 |
*EBIT = earnings before interest & taxes
*EBT = earnings before taxes
Income statements depict the cash inflows and outflows of a company. In the example above, the company sold $200,000 of product, but ended with $55,000 in net income after paying for inventory, operational expenses, interest, and taxes. From there, the company paid $20,000 in dividends to shareholders, leaving them with $35,000 of retained income. Similar to a balance sheet, it’s important to know the items that are included on an income statement, not necessarily the specifics of the line item.
Financial statements don’t always do a great job of providing detailed information. For example, what if a company suddenly reported a sharp increase in the cost of goods sold as compared to previous income statements? There could be a legitimate reason for this, like a global pandemic requiring more safety measures, resulting in rising costs. If providing details is necessary, companies provide this context in the footnotes of their financial statements. It might sound something like this:
Cost of goods sold (COGS) increased by 250% due to costs related to COVID-19 safety measures. Additional capital was spent on various items, including additional personal protective equipment (PPE), additional liability insurance, and cleaning supplies.
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