Monday, 15 June 2015

Understanding Financial Statements (Part 4) - Financial Ratios

Everything is relative, to measure something, compare it to something else
(Image source: http://didyouknow.org/the-size-of-the-sun-in-comparison/)

This is the last part on Understanding Financial Statements as it aims to uncover some important ratios that can give insight to the health of a company when comparing with those from the same industries or even comparing across industries.

P/E Ratio - Price to Earning Ratio. This is one of the more commonly used ratio, where the price of the stock is compared to the earnings of the stock

P/B Ratio - Price to Book Ratio. Not as commonly used as P/E but still important for value investors as a P/B Ratio of above 1 would represent a premium over the tangible value of the company.

Current Ratio - The ratio of current assets to current liabilities, this represents the firm's ability to repay its short-term (current) obligations. The current ratio of below 1 or just above 1 puts the company at significant risk of being unable to repay its short-term obligations, especially if its debtors are unable to repay the credit extended

Quick Ratio (Acid Test) - Similar to the current ratio with the exclusion of inventory, which as mentioned in the Balance Sheet segment of this topics, can be devalued quickly in certain industries.

Return on Equity (ROE) - Net profit of the company divided by the equity, shows the percentage returns that the company is able to return on its equity, a high ROE is usually an indication of an economic moat

Return on Assets (ROA) - Net profit of the company over assets, in my opinion not the best of measures as ROA can fluctuate greatly during each reporting period and a sudden drop in ROA may not signal a decline in the sustainability of the business

Return on Invested Capital (ROIC) - Net profit of the company divided by the equity of the company plus the lease obligations and debt minus the cash and cash equivalents held by the comapany. In my opinion, this is more useful than ROA as this represents the resources provided to the company by the various parties. This can also be used as a comparison figure to the company's cost of debt, which is the interest expense over total debt.

Free Cash Flow (a.k.a. Owner's Earnings) - Cash used in operating activities minus capital expenditure (money used to purchase or maintain PP&E). This is used to determine the amount of money that can be taken out of the business without affecting its earnings and can be used for other purposes such as acquisitions or paid out to the owners in the form of dividends

Summary

This concludes the topic of Understanding Financial Statements, hope that some of the knowledge gained can help you in your own financial freedom journey as you analyze your own investments' financial statements.

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