Common Cents Investment Group Financial Ratios and Stock Screening November 3 rd, 2008

FINANCIAL RATIOS

Financial Ratios Useful in comparing different elements of a firm versus another firm or and industry average Are somewhat weak as a stand alone metric ◦ Should be combined with other information Four major types

Liquidity Ratios Measure of the firm’s short-run ability to pay its maturing obligations ◦ Readiness of assets to be converted into cash Current Ratio: ◦ (Current Assets) / (Current Liabilities) ◦ Company’s ability to satisfy its short-term liabilities—must be careful in how much of your current assets are classified as what

Liquidity Ratios Acid-test Ratio: ◦ (“Quick Assets”) / (Current Liabilities) ◦ Similar to the current ratio, except inventories and prepaid items are excluded from current assets ◦ Provides a more accurate description of ability to meet short-term obligations

Solvency/Leverage Ratios Investors and creditors are particularly interested in a company’s long-term solvency and stability ◦ The extent to which a firm relies on creditors to finance operations rather than its owners Debt-to-Equity Ratio: ◦ (Total Liabilities) / (Shareholder’s Equity) ◦ As this ratio increases, if the company were to liquidate, less of the assets would be available to the owners because they’d be claimed by creditors

Solvency/Leverage Ratios Times Interest Earned Ratio: ◦ (EBIT) / (Interest Expense) ◦ EBIT = Net Income before Interest and Taxes ◦ Indicates the margin of safety provided to creditors ◦ The number of times a firm would be able to pay its interest expense from financing before running out of funds from operations

Efficiency Ratios How quickly certain assets (namely receivables and inventory) can be converted into cash; also called activity ratios Accounts Receivable Turnover: ◦ (Net Sales) / (Average Accts. Receivable) ◦ Measures how often their sales remain uncollected ◦ If this number is low, it may say that the firm has trouble collecting cash—especially if needed

Efficiency Ratios Inventory Turnover: ◦ (Cost of goods sold) / (Average Inventory) ◦ Measures how quickly inventory is sold ◦ Provides information about whether obsolete inventory exists ◦ Must be careful in analysis:  A low number means they are sitting on a lot of inventory which is costly to store  A too high number may indicate they face potential stock-out problems

Profitability Ratios Measures how profitable a firm is based on many dimensions Profit Margin Ratio: ◦ (Net Income) / (Net Sales) ◦ After all expenses are included, how profitable is the firm? ◦ May want to look at Operating Profit Margin instead

Profitability Ratios Return on Assets: ◦ (Net Income) / (Average Total Assets) ◦ Measures how well a company puts its assets to use ◦ A lower ratio may indicate they aren’t generating enough income to justify the cost of their assets

Profitability Ratios Return on Equity: ◦ (Net Income) / (Average Shareholder’s Equity) ◦ The higher the ratio the better ◦ Have to look at other ratios as well  For example, if the company is heavily debt- financed, this ratio (should) be higher  However, this could be dangerous if they begin to have trouble collecting cash and thus can’t pay their current debt obligations

Book Value and Market Cap Market Cap: ◦ (Current Share Price) * (# of common shares of stock outstanding) ◦ If you wanted to completely purchase the company today, how much would it cost? Book Value: ◦ (Total Assets) – (Total Liabilities) ◦ Also known as…Shareholder’s Equity!

Interpretation The accounts used in these ratios can vary based on what you perceive them to represent Book Value example: ◦ Intangibles or goodwill need to be carefully factored into Total Assets, if at all ◦ Compare to the firm’s market cap to see if it is discounted

STOCK SCREENING

Stock Screening ValueLine has a powerful component known as Stock Screening Allows you to see firms that meet specific requirements ◦ E.g.: You are only interested in firms with a P/E Ratio between 10 and 20, those who have a Return on Equity above 15%, and those with a Market Cap between $100 and $1000 million

Stock Screening Check out the CCIG website for how to initially access ValueLine Click on “Standard Edition” on the left- hand side then “Stock Screening” The combinations are nearly endless; play around with it some to get a feel!