Plan "B"

In addition to the other things I want to do this year, I'm also adding "become financially literate" to my list. I'll be the first to tell you that I have no idea of what people in the financial world are talking about when they start talking all fancy like they do. I mean, I couldn't tell you what earnings per share were if I had the earnings and the number of shares in my hand.

So, I decide to go to one of the million or so financial tutorials online to understand what I should be looking at. My instincts and cursory involvement in my own finances indicated that I should be paying attention to Income statements and Balance sheets and some important ratios contained (err, hidden) in them.

I came across this little morsel of knowledge... "The gross margin is not an exact estimate of the company's pricing strategy...". Exact estimate? What exactly is an exact estimate? Does this sentence really read, "The gross margin is a completely random value of the company's pricing strategy"? That's how I'm reading it. Well, two hours and a few examples later, I have something like an outline.

Ratio Analysis - source: http://www.investopedia.com/university/ratios/

Performance 
 Average Interest Rate (balance sheet)
  = (Interest Expense - Accounts Payable) / Liabilities
  This is a rough estimate, the ratio does not account for everything
  Using the before tax or after tax interest expense will produce different results

 Book Value Per Share BV (balance sheet)
  = (Stockholders Equity - Preferred Stock) / Average Outstanding Shares
  ($11,678 - $0) / 3271 = $3.57
  Comparing the market value to the book value can indicate whether or not the stock in overvalued or undervalued
  During bull markets the stock price is more likely to trade significantly higher than book value, 
  and in a bear market the two value's may be close to equal. 

 Cash Flow to Assets (balance sheet, cash flow)
  = Cash from Operations / Total Assets
  $4,438/14,725 = 0.30 
  Comparing to previous years is important, if the company's ratio is decreasing then they may eventually run into cash problems

 Common Size Analysis (balance sheet, cash flow, income statement)
  = Entity / Total Entity
    1999 1998
  Sales   100%  100% 
  COGS   35%  34% <---ex: $2,924/8,488 = .3444 = 34%
  Other Expenses  40%  41% 
  Net Income  17%  16% 

  Compares what proportion that an expense reduces sales, especially useful when comparing previous years
  It is also useful when comparing similar companies of different sizes to see if they have the same financial structure

 Dividend Payout Ratio (income statement)
  = Yearly Dividend per Share / Earnings per Share 
  A reduction in dividends paid is looked poorly upon by investors, and the stock price usually depreciates as investors seek other dividend paying stocks
  A stable dividend payout ratio indicates a solid dividend policy by the company's board of directors

 Earnings Per Share (EPS) (balance sheet, income statement)
  = Net Income - Dividends on Preferred Stock / Average Outstanding Shares 
  Diluted EPS means that the outstanding shares includes any convertible's or warrants outstanding
  If the company issues more shares then EPS are much harder to compare to previous years

 Gross Profit Margin (income statement)
  = Revenue - Cost of Goods Sold / Revenue 
  ($12,154-4,240) / $12,154 = 0.65
  The results may skew if the company has a very large range of products.
  This is very useful when comparing against the margins of previous years. 
  A 33% gross margin means products are marked up 50% and so on. 

 Price/Earnings Ratio (P/E Ratio or Multiple) (income statement)
  = Market Value per Share / Earnings per Share 
  $107.125 / $0.65 = 164.8
  One of the most widely used ratios, it compares the current price with earnings to see if a stock is over or under valued
  Generally a high P/E ratio means that investors are anticipating higher growth in the future.
  The average market P/E ratio is 20-25 times earnings.
  The P/E ratio can use estimated earnings to get the forward looking P/E ratio.
  Companies that are losing money do not have a P/E ratio. 


 Profit Margin (income statement)
  = Net Income / Revenue 
  $2,096 / $12,154 = 0.17
  This ratio is not useful for companies losing money, since they have no profit.
  A low profit margin can indicate pricing strategy and/or the impact competition has on margins. 

 Return on Assets (ROA or ROI) (balance sheet, income statement)
  = (Net Income + Interest Expense) / Total Assets
  $2,096 / $14,725 = 0.14
  We add the interest expense to ignore the costs associated with funding those assets

 Return on Equity (ROE) (balance sheet, income statement)
  = Net Income / Shareholder's Equity 
  $2,096 / $11,678 = 0.18
  If new shares are issued then use the weighted average of the number of shares throughout the year.
  For high growth companies you should expect a higher ROE.
  Averaging ROE over the past 5-10 years can give you a better idea of the historical growth. 

Activity
 Asset Turnover (balance sheet, income statement)
  = Revenue / Total Assets  
  $12,154 / $14,725 = 0.85
  Companies with low profit margins tend to have high asset turnover, those with high profit margins have low asset turnover 
   - it indicates pricing strategy.
  This ratio is more useful for growth companies to check if in fact they are growing revenue in proportion to sales. 

 Collection Ratio (balance sheet, income statement)
  = Accounts Receivable / (Revenue/365)
  $1,242 / ($12,154/365) = 37.3
  A high ratio indicates that the company is having problems getting paid for services or products.
  The ratio is sometimes seasonally affected, rising during busy seasons and falling during the off-season. 
  To account for this seasonality, the average accounts receivable 
   ((beginning + ending accounts receivable)/2) could be used instead. 

 Inventory Turnover (balance sheet, income statement)
  = Cost of Goods Sold / Average or Current Period Inventory 
  $4,240 / $652 = 6.50
  A low turnover is usually a bad sign because products tend to deteriorate as they sit in a warehouse.
  Companies selling perishable items have very high turnover.
  For more accurate inventory turnover figures, the average inventory figure, 
   ((beginning inventory + ending inventory)/2), 
   is used when computing inventory turnover. 
  Average inventory accounts for any seasonality effects on the ratio. 

Financing
 Debt / Asset Ratio (balance sheet)
  = Total Liabilities  / Total Assets  
  $3,003 / $14,725 = 0.20
  This ratio is very similar to the debt-equity ratio
  A ratio under 1 means a majority of assets are financed through equity
  Above 1 means they are financed more by debt. 
  Furthermore you can interpret a high ratio as a "highly debt leveraged firm". 

 Debt / Equity Ratio (balance sheet)
  = Total Liabilities / Shareholders Equity  
  $3,003 / $11,678 = 0.26 
   A ratio greater than one means assets are mainly financed with debt, less than one means equity provides a majority of the financing.
  If the ratio is high (financed more with debt) then the company is in a risky position - especially if interest rates are on the rise.



Liquidity Warnings

 Acid Test (Quick Ratio) (balance sheet)
  = (Cash + Accounts Receivable + Short-term Investments) / Current Liabilities 
  $827+$1189+$1242 / 3003 = 1.08
  An extreme version of the working capital ratio because it only uses cash and equivalents
  The ratio excludes inventory, which for some companies can make up a large portion of its assets

 Interest Coverage (income statement)
  = EBITDA / Interest Expense
  A ratio under 1 means that the company is having problems generating enough cash flow to pay its interest expenses.
  Ideally you want the ratio to be over 1.5.

 Working Capital (Current Ratio) (balance sheet)
  = Current Assets / Current Liabilities  
  $4,615 / $3003 = 1.54
  If the ratio is less than one then they have negative working capital.
  A high working capital ratio isn't always a good thing, it could indicate that they have too much inventory or they are not investing their excess cash.