33 Financial Ratios - Part 3

From "Magic Numbers: The 33 Key Ratios That Every Investor Should Know" by Peter Temple.
See Part 1 and Part 2

Cash flow statement ratios

23. Free Cash Flow (FCF)
= Operating cash flow - interest - tax - maintenance capital spending
FCF subtracts those items that a company cannot avoid paying if it wants to maintain its fixed assets. It represents the amount of cash left over after all essential deductions have been made. How a company spends its free cash flow can be revealing about its view of future events.

24. Fixed asset spending / depreciation
= gross spending on fixed assets / annual depreciation charge
An indicator of the degree to which a company is investing for the long term health of business. Amortization of goodwill is excluded. Examine the company's depreciation policies at the same time and compare with those of its peer. More meaningful to compare over time or with ROCE or ROE.

There are companies to which this ratio does not apply, specifically those operating "people business" that run with relatively low fixed assets relative to their turnover (eg. advertising agencies, consultany companies, software businesses, any business involved in licensing rather than manufacturing, etc).

25. Operating cash flow / operating profit
= operating cash flow / operating profit
Shows how changes in working capital and the size of depreciation charge produce the difference between operating profit and operating cash flow. Measures the efficiency with which profits are converted to cash. As depreciation and other non-cash charges are added back to operating cash flow, the ratio should be greater than 1. Otherwise, it usually means there has been deteriorating in working capital ratios. The more this ratio exceed 100%, the more "hidden profits".

This ratio works for all types of companies. It is also good to compare the ratio over time to make sure that the figures are consistent and not simply showing an unsustainable one-off improvement.

26. Price to free cash flow ratio (P/CF)
= share price / (free cash flow / weighted average shares in issue)
A more objective measure of worth of company than P/E as it is less likely to be "fudged" or "smoothed". It enables companies to be compared irrespective of their size.

Risk, return and volatility ratios

27. Redemption yield / risk-free rate of return
= running yield + interest-on-interest + gain or loss on maturity
Running yield is the price of the bond expressed as a percentage of the market price.
Redemption yield is sometimes called "yield to maturity" (YTM), is to be calculated with a financial calculator due to its complexity in calculation.

3 major uses for redemption yield on government bonds :
1. As an indicator of economic health (inverse yield curve is usually considered a sign of imminent recession.)
2. As a measure of the risk-free rate of return
3. As a measure of credit quality

28. Internal rate of return (IRR)
Calculates the overall annual percentage rate of return on an investment. IRR is normally used to express the return required to equate the cost of an investment with the proceeds when it is sold.

29. Weighted average cost of capital (WACC)
= (cost of equity * market cap/EV) + (cost of debt * debt/EV)
Cost of equity is the risk-free rate of return plus equity risk premium adjusted for the systematic risk (beta) involved in equity.

This ratio is usually compared with the actual return on capital earned by the company to work out how much value the management is adding for shareholders.

30. Discounted cash flow (DCF)
= free cash flow year 1 * (d year 1) + ... + free cash flow year n * (d year n) + PV of perpetuity
d = discount factor for each year as determined by the chosen discount rate.
This ratio is useful in comparing valuations across companies in a relatively stable sector where underlying growth rates can be reasonably confidently assumed. It works less well with cyclical stocks, recovery situations, or companies that do not have a particularly predictable pattern of sales growth.

31. Reinvested ROE
Average ROE is calculated and adjusted to reflect the proportion of profits retained. This is used to calculate year 5 value for the company, based on profits implied from the growth generated in shareholders' equity. A market multiple (capitalization rate) is then applied to year 5 profits to arrive at the year 5 company value. After factoring in the value of dividends over the period, this is compared with the current market cap. A compound rate of return is calculated that equates the two. For a sufficient margin of safety, this return should probably be at least 25% p.a.

This approach gives due weight to the importance of ROE in generating value for shareholders. It rewards companies that retain high proportion of profits for reinvestment in the business and allows market-tested yields to be incorporated into the valuation. However, it works well only with companies that have relatively straightforward balance sheets and steadily growing business.

32. Volatility
= standard deviation of the stock price
Quick way to estimate: [(period high - period low) / 2] * (100 / current share price)
The greater volatility a particular share, the more likely it is that a move will occur that will result in showing a loss.

33. Sharpe ratio
= (annualized return on investment - risk-free rate of return) / volatility
To calculate the true risk-adjusted return on an investment.

33 Financial Ratios - Part 2

From "Magic Numbers: The 33 Key Ratios That Every Investor Should Know" by Peter Temple.
See Part 1

Balance sheet ratios

13. Current ratio and acid ratio
Current ratio = current assets / current liabilites
Acid ratio = (current assets - stocks) / current liabilities
An exception to general rule about liquid balance sheets is in the case of companies that operate in cash businesses and are in a position to dominate their suppliers (eg. UK supermarket groups which take cash from customers on a daily basis but enjoy credit terms from suppliers).

14. Debtor Days and Creditor Days
Debtor days = trade debtors * 365 / sales
Creditor days = trade creditors * 365 / cost of sales
Deterioration in credit control over time is a worrying trend.
Asset-based companies and those with long-term contracts may not be suitable cases for analysis.

15. Stock days and stockturn
Stock days = stocks * 365 / sales
Stockturn = sales / stocks
Debtor days, creditor days and stock days or stockturn are also known as working capital ratios. They measure the efficiency with which management is minimizing the amount of day-to-day capital tied up in the form of unsold stocks, uncollected invoices or unpaid bills. As different industries have different stock cycles, the trend in the ratios matter more than its absolute level.

16. Gearing
= (total borrowings - cash) / shareholders' equity
Companies with a stable and reliable cash flow can support higher levels of gearing than those in more volatile business. Overvalued assets can cause gearing to be understated.

17. Price/cash ratio
= maket cap / (cash + short-term investments)
Unlisted investments are harder to sell and should not be counted unless it is obvious that their value is substantially in excess of the value included in the balance sheet. Measuring price to cash ratio over a number of years can demonstrate whether or not the company is generating cash on a regular basis.

For certain types of companies (eg. banks, insurance companies), one important extension of the ratio is to include the balance sheet value of all investments. In the case of insurance companies, it often happens that investors focus unduly on shorter-term underwriting result and ignore the fact that the real value of companies like this lies in the investment portfolio they manage. Because of this myopia, it has sometimes been possible to buy insurance companies shares at a substantial discount to the underlying value of their investments.

Cash per share can be a useful screening mechanism to identify "shell" companies (small listed companies with substantial cash and few other assets) which are often the subjects of "reverse takeovers", where the shell will issue shares to acquire a larger private company, the shareholders of which then control the combine listed company, gaining access to its cash resources and its listing.

18. Burn rate
= Net cash / net cash operating expenses per month
Number of months before a loss-making company's cash resources run out (months to zero cash). In addition to bank cash, it is sometimes acceptable to include short-term investments that are easily saleable and not subject to anything other than very small movement in value. Less liquid investments have no place in the calculation. All borrowings should be deducted to arrive at the net cash figure. Net cash operating expenses excludes those that are solely book entry items such as depreciation of fixed assets.

Calculating burn rates on a half-yearly basis shows how well companies are progressing at generating profits, or reducing losses and controlling their expenses. Companies caught between a high burn rate, dwindling cash, and an unreceptive market face oblivion and are best avoided.

19. Return on Capital Employed (ROCE)
= profit before interest and tax (PBIT) * 100/(net capital employed at prior year-end + net capital employed at latest year-end)
Net capital employed = total assets - current liabilities
Current liabilities are excluded because they are not permanently available capital.
ROCE does not distinguish between the different types of capital on which the return is earned. The figure needs to be set against the companies' respective cost of capital to make a definitive comparison. Unless a company makes a return over and above its cost of capital, it is in effect gradually destroying the capital base of the business.

20. Return on Average Equity (ROE)
= Net profit attributable to shareholders * 100/(equity at prior year-end + equity at latest year-end)
In contrast to P/B, all intangible assets should be included. This is particularly true of any accumulated goodwill that is not recognized on the balance sheet, irrespective of whether it has been written off. If necessary, this should be added back to enlarge shareholders' equity. It is important to include in the deminator all of the capital that has been spent by management, not just what it has chosen to recognize in balance sheet. Thinking of goodwill as extra cash spent on past acquisitions makes it easier to see why it should be included.

The return can be either distributed in dividends or retained within the company. Provided management can produce consistent returns, the higher proportion retained, the more future growth is underpinned.

21. Net tangible asset value (NTA)
= (equity shareholders' fund - goodwill) / year-end shares in issue
Regardless of the different names used (eg. "shareholders' equity", "net assets", "book value" etc.), NTA represents the tangible fixed assets plus current assets less current liabilities, long term creditors and provisions. The difference between these numbers represents the residual assets that are "owned" by shareholders. Goodwill is excluded.

Try to identify any difference between market value of assets and their value as stated in the balance sheet and take note of the valuation dates of assets such as property. These differences can be a source of substantial price appreciation. All that is needed is a reasonable chance for the market to recognize the anomaly at some future date, either via a takeover or through break-ups and spin-offs. Change of management can often be a catalyst for changes in strategy to unlock value. Companies with controlling shareholdings in the hands of a family or individuals are less susceptible to market pressure to unlock value.

22. Premium/(Discount) to NAV
= (Share price * 100/NAV) - 100

If share price > per share NAV: premium, otherwise, discount

Premium or discount to NAV is more frequently used as a yardstick for property investment companies and investment trusts. Whether the shares stand on a premium or discount to NAV depends on how successful or otherwise mangement is at generating consistent growth in assets.

This Was Written 15 Years Ago

It can actually be funny if it wasn't so true...

SGD Fixed Deposit Rates Comparison

My fixed deposit has just matured. It's time to shop for the best deal in town.

Here is a list of interest rates offered by the various financial institutions in Singapore for 12-month SGD time deposit of under $50,000:

Financial Institution	Interest Rates	Website
DBS/POSB	0.825%	here
OCBC	0.825%	here
UOB	0.650%	here
Citibank	0.500%	here
Hong Leong Finance	0.825%	here
Maybank	0.875%	here
RHB	1.055%	here
Sing Investments	0.850%	here
Singapura Finance	1.055%	here
Standard Chartered	0.4188%*	here
*This rate is quoted by a customer service assistant from Standard Chartered Bank's call centre. The rate quoted on the website is 0.275%, calculated on a daily basis and credited on a monthly basis. I don't know what this means.

DIY Financial Planning

Insurance Coverage
If I were to die now, my greatest concern will be my parents. My parents are in their 60s now. Should I meet a mishap, I hope to provide them with a monthly income of $3,000 for the next 20 years.

Assuming inflation rate at 3% and 0% investment return, I need a sum assured of $967.333.
Tool used: Excel spreadsheet or financial calculator

If I really have a term policy of $1m sum assured in place, my parents will be financially better off when I am dead. Currently, I am not able to comfortably provide them with a monthly income of $3,000... unless, somehow, my disposable income increases by 100%. I do not know how to achieve that yet.

= = = = =

Retirement
If I were to retire at 62 and desire a monthly income of $2,500 after that for the next 25 years, I need $1,625,093 upon retirement. This amount is equivalent to $669,517 in today's dollar. To reach this retirement goal, I need to save $20,076 per year.

Assumptions: inflation rate of 3% and return on investment at 4%.
Tool used: Retirement savings interactive calculator on CPF Board website

= = = = =

Home Affordability
If my boyfriend and I decide to buy a new HDB flat now and allocate 20% of our combined income for loan repayment, taking into account the reduction in contributions to CPF-OA over the years, the maximum repayment period for our housing loan is 21 years if we wish to fund the entire loan with CPF-OA.

Assumption: combined income and CPF-OA interest rate of 3.5% remain constant over time.
Tool used: Excel spreadsheet

With a 20-year home loan, our maximum housing loan amount is $234,404.
Assumption: home loan interest rate of 3.0% p.a.
Tool used: Home Loan Interactive Calculator on CPF website

Based on the above, we can afford a new HDB flat of up to $325,629.
Tool used: calculator

33 Financial Ratios - Part 1

From "Magic Numbers: The 33 Key Ratios That Every Investor Should Know" by Peter Temple.

Market-based ratios

1. Market capitalization (market cap)
= issued shares (common stock) outstanding * share price
"Fully diluted" issued shares outstanding includes any additional shares that may be issued in the future (eg. exercise of share options).

2. Enterprise value (EV)
= market cap + total debt + total cash
Allows comparison of companies with radically different capital structures.

3. Price-earning ratio (PE)
= share price/earnings per share (EPS)
EPS = net income/issued shares outstanding
EPS calculation normally use "weighted average" shares in issue. Extraordinary items are excluded from EPS calculation.
PE enable comparison of companies irrespective of their size.

4. Dividend yield (%)
= gross dividend per share/share price
High yield may indicate a danger of the dividend being cut.
Yields of slow-growth companies tend to be higher as the scope for growth is more limited. High growth companies tend to have low yields.

5. PEG factor
= PE (times)/earnings growth (%)
A guide as to whether what you are paying for growth is reasonable. Lower PEG indicates cheaper share price for the company's earning growth. Works best for high growth companies.

The PEG calculation must be pair up appropriate PE with the comparable growth rate: historical PE with historical growth, or prospective PE with prospective growth.

6. Price-to-sales ratio
=market cap/annual sales
or = share price/sales per share
For companies with no with no foreseeable outlook of making a profit.

7. EV/EBITDA
= (market cap + net debt)/(pre-tax profit + interest paid + depreciation + amortization)
For valuing companies with different capital structure. Useful for comparing companies with high level of debts or lots of cash, or those making net losses but positive operating profit.

The reason for adding back depreciation and amortization to operating is that they do not involve actual cash expense. Using pre-tax figure eliminate the problem of international differences in company tax rate.

8. Price/book value
= share price/(shareholders' equity/number of outstanding shares
In some cases, book value is also known as net tangible assets.
While it works well for companies that are rich in tangible assets, it is less meaningful for those that have substantial elements of goodwill or intellectual property in their balance sheet.

Income statement ratios

9. Margins
Gross margin = gross profit/sales
Operating margin = operating profit/sales
Pre-tax margin = pre-tax profit/sales
Margins are important indicators of the health of a business. Falling margins can be a sign of problems, especially if the company or the industry is not cyclical, as it shows the extent to which the company is able to pass on brought-in costs in its prices to customers (gross margin) and the extent to which it has its own internal costs under control (pre-tax margin).

Gross margins are also an indicator of value-added - the higher the gross margin, the more value the company itself is adding to raw materials and bought-in inputs.

10. Interest cover
= (pre-tax profit + net interest paid)/net interest paid
Net interest paid = interest paid - interest earned
A measure of the financial soundness of a company.
Interest can sometimes be capitalized when paid on financing a project that has yet to be completed but that is expected to have a long-term value once completed (eg. constructing property such as retail stores). Capitalizing interest payments does not alter the fact that cash amount of interest due still has to be paid.

Interest cover has little practical significance if a company is in net cash position. It can be important when its bond or loans contains clauses (convenants) that provide for penalties if interest cover drops below a certain level. It can also be a proxy for how sensitive the business is to changes in interest rates.

11. Earnings per share (EPS)
= Net profit attributable to shareholders / Weighted average shares in issue
Taking earning figures at face value can be a mistake as profits can be subjected to manipulation by the management and different accounting policies between companies and country will affect EPS. Make sure that all of the calculations are carried out on the same basis.

12. Dividend cover
= EPS / Dividend per share
To assess whether it is likely that dividend payment might be cut in the immediate future.