Monkey Business, John Rolfe and Peter Troob

An intense book. I'd call it 'fair warning' for those of us thinking of 'swinging through the wall street jungle' as the tag line suggests. It's a collection of sordid stories about the life of investment bankers from Harvard and Wharton. A good read even if you have little interest in banking.

This book focuses on the life cycle of an associate (what I'm hoping to become when I finish my MBA). It outlines all the details, starting from recruitment for the summer internship at DLJ right up until the moment they decide to leave the investment banking world.

A timely read for those of us also writing our CFAs with great aspirations. Get a preview about what you are potentially getting into. No surprises.

Sent from my BlackBerry device on the Rogers Wireless Network

Posting Shortfall

I apologize for my regular readers who were expecting CFA related posts for the past three days on this blog, only to be disappointed.

This weekend, I received an offer for an internship in New York city with an equities research firm and I've been busy sorting out which visa status I need to undertake so I've been busy with calls to various sponsorship agencies like SWAP USA, CDS and AIPT as well as the US Consulate and CBP.

Also, OSAP recently underwent an upgrade and opened yesterday, but the traffic was so bad, I got booted from the system for 24h (if you read my post on BCP, you'd understand why I was a little annoyed). I just finished my student loan application through OSAP and am now waiting for final approval for my government loan.

Also, there was a 'Meet the Dean' session at Rotman as well as a free lance consulting project meeting that I had to take care of Monday evening. I have been reviewing, but I covered most of the interesting topics and am now working on topics which I'm having particular trouble with (so I can't pretend to have any sort of expertise in posting the solutions here).

However, if I do encounter interesting topics which would make good posts, I'll take a break from answering questions and put up a post here.

2 Week Hiatus

I will be going on a two week hiatus in preparation for the CFA Examination on Saturday June 6th, 2009.

However, I will continue to post on Amongst the Stars, my Investment Blog, with a focus on CFA level I examination related topics and concepts.

Wish me luck!

Financial Ratios, pt 4 - Profitability Ratios

[ Financial Ratios, Part: 1 - 2 - 3 - 4 ]

Profitability ratios are probably the most universally understood ratio because of their direct impact on the bottom line as well as they encompass the idea of adding and creating value (the foundation of the capitalist structure). They describe the financial efficiency of an organization as well as provide a basis for valuation ratios such as PE ratios.

Return on Sales
Return on sales margins use revenue in the denominator. By looking at the operations process, company management can determine their profitability at different stages.

Gross Profit Margin = Gross profit / revenue
Net Profit Margin = Net income / Revenue

Return on Investment

Return on Assets (ROA) = Net Income / Average Total Assets
Return on Equity (ROE) = Net Income / Average Total Equity

The two major components of DuPont Analysis, these two ratios summarize some of the most fundamentally important concepts in investing. How much have I put in, and how much am I getting out? Higher ROAs and ROEs are the target of any good security. The only downside to extremely high ROAs or ROEs is that the earnings are usually volatile (risk. Or in other words, something that looks too good to be true, usually is).

[ Financial Ratios, Part: 1 - 2 - 3 - 4 ]

Financial Ratios, pt 3 - Solvency Ratios

[ Financial Ratios, Part: 1 - 2 - 3 - 4 ]

Solvency ratios are similar to liquidity ratios except that they focus on the long term ability of the firm to meet it's debt obligations. As a result, by looking at solvency ratios, you can determine leverage, coverage, etc.

Because solvency looks at the broadest measures of financial position, the terms which most often appear in solvency ratios are the bottom lines of balance sheets (Assets, Debt and Equity). Recall the fundamental accounting principle that

Assets = Liabilities + Equity

Basic Solvency Ratios:

Debt-to-Assets = Debt / Assets
Debt-to-Equity = Debt / Equity

Financial Leverage of Assets (FLA):

Financial Leverage = Assets / Equity

A critical part of DuPont Analysis, Financial Leverage also identifies the overall riskiness of the company (higher leverage = higher risk) and directly affects return on equity (ROE). Financial leverage is the cornerstone of financial investing and can turn a "good deal into a great deal".

Note that FLA can be determined from D/E.
FLA = A/E
= ((D+E) / E)
= E/E + D/E
= 1 + D/E

Interest Coverage:

Interest Coverage = EBIT / Interest Payments

Interest Coverage describes your ability to make interest payments. If this is less than 1 this is a *DISASTER*. It means that not only do you have enough money to make your interest payments, but you can't even begin to consider paying down your principle let alone think about profits. This also implies that your principle will grow (interest not immediately paid off becomes part of the new principle amount). I would expect any company with an interest coverage ratio of less than one is quickly and unceremoniously headed for bankruptcy.

By that very token, I would suggest that this ratio isn't actually very useful except to tell you how much trouble you are in (at a time when it's too late BTW). Since the numerator is EBIT (which is directly related to net income and retained earnings), you generally want this number as sustainably high as possible) so unlike some of the previous ratios, there is very little downside to having exorbitantly high interest coverage ratios.

Fixed Charge Coverage

Fixed Charge Coverage = [EBIT + lease payments] / [Interest + lease payments]

Similar to the idea of the interest coverage ratio, the fixed charge ratio takes into account lease payments. It is a little more all encompassing in that it also considers lease payments (not considered discretionary).

[ Financial Ratios, Part: 1 - 2 - 3 - 4 ]

Financial Ratios, pt 2 - Liquidity Ratios

[ Financial Ratios, Part: 1 - 2 - 3 - 4 ]

Liquidity ratios are very important ratios which describe the company's ability to meet its short term obligations. Liquidity shortfalls (liquidity ratios of less than 1) indicate cash flow problems and may require the company to acquire short term financing on short notice (usually the larger and more urgent the need for "convenient" cash, the more expensive the financing).

The three most common liquidity ratios are the Current ratio, Quick ratio and Cash ratio (increasingly conservative ratios). These ratios are also related to the activity ratios we had previously discussed.

In each of the ratios the denominator is the current liabilities.

Current Ratio

Current Ratio = Current Assets / Current Liabilities

Probably the easiest to calculate (seeing as Current Assets is a line item in a Balance Sheet). It is the broadest liquidity ratio, including all current assets. As a result it is also the least conservative.

Quick Ratio

Quick Ratio = [Cash + Equivalents + Receivables] / Current Liabilities

While Current Ratio takes into consideration all of your assets, what if you determine that your inventory is not liquid enough (not enough turn over) to be able to contribute to your liquidity (maybe you sell large products infrequently - looking at your inventory turn over should give you an idea). By removing inventory from consideration as relatively illiquid, the quick ratio is a more conservative measure of liquidity.

Cash Ratio

Cash Ratio = [Cash + Equivalents] / Current Liabilities

The most conservative of all ratios is the cash ratio. It literally assumes that all your receivables go into default (doesn't include them in the numerator) and is very much a "bird in the hand is better than two in the bush" measure of liquidity. A company with a cash ratio of 1 or higher has a very low likelihood of short term cash flow issues as they can cover all their liabilities with cash.

While having a high liquidity ratio is generally good, having TOO high a liquidity ratio can be just as bad. How is that? Because it means that you are inefficiently using your capital. A company which has good asset turn over and few default accounts would be foolish to have a Cash Ratio of 1. Having liquidity is another form of safety, and following the golden rule of investing: the more risk you can reasonably assume, the more return you can expect.

[Example] A company has a Current ratio of 2, a Quick ratio of 0.9 and a Cash ratio of 0.8. If the company is about to order more supplies to create more inventory, what is the net effect on each ratio?

[Solution] First, assuming that the value of the supplies (AP a current liability) is equal to the increase in inventory (Inv a current asset), the net affect will be as follows:

• For a ratio containing inventory in the numerator, the ratio will approach 1 (numerator and denominator increase at an equal rate, but are still weighted with previous values).
• For a ratio NOT containing inventory in the numerator, the ratio will decrease in size (denominator increases)

This means that:

1. The Current ratio, which contains inventory, but is greater than 1, will get smaller (closer to 1).
2. The Quick ratio, which contains inventory, but is smaller than 1, will get larger (closer to 1).
3. The Cash ratio, which does NOT contain inventory, will get smaller.

[ Financial Ratios, Part: 1 - 2 - 3 - 4 ]

Financial Ratios, pt 1 - Activity Ratios

[ Financial Ratios, Part: 1 - 2 - 3 - 4 ]

An important component of financial statement analysis is comparisons based on financial ratios. Financial ratios normalize information against size and provide a baseline for comparison with previous years as well as competitors. While comparing two financial ratios may seem meaningless on the surface, comparing two numbers from the past or with a competitor can give information about direction and relative performance.

As with any mathematical ratio, you have a numerator and a denominator. Each financial ratio contains different items in the numerator and denominator and are therefore subject to certain bias or able to describe different aspects. Again, ratios describe interesting relationships when near the value of 1, meaning the numerator is higher than the denominator (for ratios such as coverages etc).

This post will focus on Activity (Operational) financial ratios. These are ratios that measure the efficiency of operations (payables, receivables, inventory, COGS etc).

I had written a post previously about cash flow as the life blood of business in my management consulting blog which deals with the basics of cash flow as well as some queuing theory.

Inventory Ratios

Inventory Turnover = COGS / Average Inv

Inventory turnover describes how many times over an inventory is sold. A high inventory turnover probably indicates that your product moves well, or (in a more negative sense) that you aren't stocking enough and possibly losing out on sales because of stock outs.

Days of Inventory on hand (DOH) =
Number of days in period (usually 365) / Inventory Turnover

DOH is a measure of how long your inventory is sitting idle in storehouses or distribution centers before being sold off (converted) in accounts receivable.

Receivables Ratios

Receivables Turnover = Revenue / Average Receivables

In a parallel train of thought as inventory turn over, receivable turnover is a measure of how much value is sitting in revenue relative to AR. As a collelery to the previous concepts:

Days of Sales Outstanding (DSO) =
Number of days in period (usually 365) / Receivables Turnovers

This describes how long revenues are accrued before being collected on average during the operating year.

Payables Ratios:

Payables Turnover = Purchases from Suppliers / Average Payables

Number of days payable =
Number of days in period (usually 365) / Receivables Turnovers

You'll note the pattern where the you can subsititue either the word 'inventory', 'receivables' or 'payables' using the same formulas to see different relations. In this case, how long it takes for you to pay your suppliers.

[ Financial Ratios, Part: 1 - 2 - 3 - 4 ]