SeeWhy Financial Learning

Investment Analysis
Financial Ratios

Company Analysis: The Financial Ratios

You have just passed CSC #1 and you are feeling pretty good about yourself, as well you
should; that's a great accomplishment! Now you open CSC Volume II and one of the first
things you come across is all of the financial ratios. These can be very intimidating, but don't
worry...SeeWhy Financial Learning is here to help!
In our experience, you are not likely to have to actually calculate more than 2 or 3 financial
ratios; in fact, you will probably use your calculator only 6 or 7 times at most on the entire
exam. Much like CSC #1, this is not a math test.

Financial Ratio Analysis

There are several financial ratios that can be calculated and examined to help assess a
companys performance and financial health. It is important to note that one ratio on its own
tells you very little. To understand this, consider an individual who earns $150,000 per year.
That is a very attractive salary but does this necessarily mean he is in good financial shape?
To answer that question, you would need to also look at his net worth, current liabilities, etc.
The same holds true for a company. However, when several ratios are looked at together they
begin to tell a story.
Financial ratios can be divided into four categories. To remember the four categories just
remember that there is a:
List Of Various Ratios
Liquidity
Operating
Value
Risk analysis
On the exam, you will be required to know which ratios fall under which category. For
example, you could be asked a question like, "Which category does the inventory turnover
ratio fall under?"
Below is the list of ratios that are discussed in your text, including which broad category they
fall under. For some of these ratios, this will be all you need to know about them (the category
they fall under).

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Investment Analysis
Financial Ratios

Liquidity

Current ratio (also known as the working capital ratio)

Quick ratio (also known as the acid test)
Operating Cash Flow

Operating
You operate a business to turn a profit.
Operating performance ratios all have the words profit or turn in them.

Profit margin ratios

Return ratios
Inventory turnover

Value

Dividend payout ratio

Earnings per share
Dividend yield
Price earnings ratio
Enterprise multiple

Risk analysis
All Deal with debt or an obligation of debt (interest) or preferred shares (dividends)

Asset coverage
Percentage of capital ratios
Debt / Equity
Cash flow / total debt
Interest coverage
Preferred dividend coverage

Exam tip:

Memorize three of the four categories and assume that any you dont know
recognize fall under the fourth category.

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Investment Analysis
Financial Ratios

The actual textbook discusses close to 30 different financial ratios. In dealing with these
ratios, we encourage you to ask yourself, "Why did I buy this study guide?"
While you obviously have an interest in learning the material, most students buy this guide
because they want to pass the exam. This is where SeeWhy Financial Learnings expertise is
invaluable because we know what to focus on for the exam. Historically speaking, there are
generally 4 - 6 six questions on the exam where you may have to calculate and/or comment on
the financial ratios. We have narrowed the list of 30 ratios down to 10 "must know" ratios. If
you know and understand the following ratios well, you will get most, if not all, of these marks,
and you will have saved yourself a ton of study time.
The ratios we recommend knowing are:

Current ratio (also known as the working capital ratio)

Quick ratio (also known as acid test)
Debt/Equity
Dividend payout ratio
Dividend yield
Percentage of capital ratios (already discussed)
Earnings per share (EPS)
Price earnings (P/E) ratio (almost always tested)
Inventory turnover ratio
Pre-tax Cost of a Dividend

For each of these 10 ratios, we will:

Summarize what the ratio is.

Help you understand what exactly the ratio tells you.

Give you hints as to how they might word a question on the exam, which will prompt you
to use the appropriate ratio.

Provide other things to know or advice for the exam.

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Investment Analysis
Financial Ratios

Current Ratio and Quick Ratio

Formula(s):
Current ratio (working capital)

Quick ratio (Acid test)

Current assets
Current liabilities

Current assets - Inventories

Current liabilities

What these ratios tell you:

Both of these ratios are measures of liquidity. In other words, they give you an idea of whether
or not the company will be able to make its short-term (current) liability payments.
What you will see in the exam question if they want you to use this formula:
If they ask you to comment on a companys liquidity and tell you to use the most stringent test,
you would use the quick ratio.
If they ask you to comment on a companys liquidity and tell you to use the least stringent test,
you would use the current ratio.
Other things to know:

If a company has poor liquidity, it could mean that it will have trouble meeting its short-term
financial obligations. On the other hand, too much liquidity could be a warning sign that the
company is being poorly managed. If management has too much cash sitting idle (not being
used) it provokes the following question: Why dont you have this cash actively employed in
the business and earning us profits?
Current assets are assets that are either cash, or are likely to be converted to cash, within one
year. Current liabilities are liabilities that are due and payable within one year.

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Investment Analysis
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Debt/Equity
Formula:
Debt/Equity

Total debt (Short-term + Long-term)

Total equity (all 5-comonents of equity)

What this ratio tells you:

This ratio tells you the proportion of borrowed funds relative to the amount of money that
shareholders have invested into the company. Too high a Debt/Equity ratio could mean the
company has borrowed excessively, which would increase the financial risk of the company. It
would be similar to a person with very little net worth but a whole lot of debt.
What you will see in the exam question if they want you to use this formula:
Any questions on Debt/Equity will usually specifically ask you about the companys debt in
relationship to its equity.
Other things to know:
The hardest thing about calculating this formula is knowing what is considered debt and what is
considered equity.
Debt includes:

Short-term loans (like bank advances)

Long-term loans (like mortgages)
Bonds and debentures outstanding
Etc.
Note: Debt does not include accounts payable!

Equity Includes:
Common share capital
Preferred share capital
Retained earnings
Foreign currency translation adjustment
Contributed surplus.
Remember our memory aid: Companies Prefer Retaining Fantastic Coaches

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Investment Analysis
Financial Ratios

Dividend Payout Ratio

Formula:
Dividend Payout ratio

Dividend per common share

Earnings per common share

or

Dividend Payout ratio

Note:

Total dividends paid to common shares

Total common share earnings

There are two ways to calculate this ratio. Both methods will result in the same
answer, but you must know both because you dont know what information they will
provide you with in the question.

What this ratio tells you:

This ratio tells you what percentage of the common share earnings the company pays out as a
common share dividend. The rest will be retained in the company to finance future growth.
What you will see in the exam question if they want you to use this formula:
If they give you information on a few different companies and ask you which is more generous
in sharing its profits with shareholders, you will use the dividend payout ratio.
Other things to know:
If you are given the above question, be careful to not just answer the company that pays the
biggest dividend. Instead, calculate which company paid the highest dividend in relationship to
earnings.
For example:
ABC had $1.00 EPS and paid out a $1.00 dividend (ABC paid out 100% of earnings)
DEF had $10.00 EPS and paid out a $2.00 dividend (DEF paid out only 20% of earnings)

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Investment Analysis
Financial Ratios

Dividend Yield
Formula:
Dividend Yield

Common (or Preferred) share dividend

Current market price of that share

What this ratio tells you:

What percentage the dividend is of the current market value of the stock. A client looking for
income would prefer a higher yielding stock.
What you will see in the exam question if they want you to use this formula
They will usually just ask you about the common or preferred share's dividend yield.
Other things to know:
This may seem like a new formula to you but it is basically the same as the current yield formula
you learned in CSC #1. The only difference is when calculating current yield, you used interest
(because bonds pay interest) and with divided yield, you use the dividend (because shares pay
dividends).

Percentage of Capital ratios

Formula:
Invested capital attributable to ??????

??????
Invested capital

This formula was discussed in great length earlier in the chapter. We only mention them again
here because we dont want you to forget them just because they are not specifically mentioned
in the financial ratios section.

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Investment Analysis
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Earnings per Common Share (EPS)

Formula:
EPS

Net earnings Preferred dividends

Number of common shares outstanding

What this ratio tells you:

The earnings on a per share basis.
What you will see in the exam question if they want you to use this formula
They will ask usually just ask you for the earnings per common share or "EPS".
Other things to know:
We are deducting preferred dividends from the net earnings because the preferred share
dividends must be paid to the preferred shareholders before the company is allowed to pay any
dividends to the common shareholders.

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Investment Analysis
Financial Ratios

Price Earnings (P/E) Ratio

Formula:
P/E

Price of common Share

Earnings per common share

What this ratio tells you:

This ratio tells you how much investors are paying per dollar of income that the company
currently earns.
What you will see in the exam question if they want you to use this formula

If they ask you how expensive a stock is.

If they ask you, for which company the market is paying the most for its earnings.
If they ask you, for which stock does the market have the highest regard.

Other things to know:

When asked any of the above three questions you NEVER look at the market price only. The
price can be artificially increased or decreased by the company performing a stock split or stock
consolidation without anything substantially changing with the company. For this reason, we
must look at price in relation to earnings.
For example: Which of the following stocks is the most expensive?

ABC has earnings of $1.00 per share and has a market price of $50. What is its P/E?
P/E = 50X, calculated as follows: $50 / $1 = 50X
DEF has earnings of $50 per share and a market price of $50 share. What is its P/E?
P/E = 1X, calculated as follows: $50 / $50 = 1X
This is an exaggerated example for learning purposes but clearly, ABC is a relatively expensive
stock. You are paying $50 for every $1 the company earns as compared to DEF where you are
only paying $1 for every $1 the company earns.
IMPORTANT:

The P/E ratio is also called the P/E multiple, as in multiply. This is why you
see P/E as a "X" -- it means "times", as in "50 times earnings". You are
paying 50 times earnings for ABC stock.

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Investment Analysis
Financial Ratios

Inventory Turnover Ratio

Formula:

Inventory Turnover ratio

Cost of goods sold

Inventory

or
Inventory Turnover ratio
Note:

Net sales
Inventory

There are two ways to calculate this ratio. You need to know both because you dont
know what information they will provide you with in the question.

What this ratio tells you:

This ratio tells you how many times per year a company turns over its inventory. For example,
if a T-shirt store generally has $10,000 worth of inventory and sells $10,000 worth of t-shirts
each month, they turn over their inventory once per month.
What you will see in the exam question if they want you to use this formula
They will give you information on two different companies and ask you which company does a
better job of turning over its inventory. The company with the highest inventory turnover ratio
(within reason) is the one that does a better job of turning over its inventory.
Other things to know:
Inventory turnover rates should only be compared to the inventory turnover rates of companies
in the same industry. It would make little sense comparing the turnover rate of a hamburger
joint to the turnover rate of a car dealership.
Too low an inventory turnover rate could be a concern. It could mean:
the company has an unusually high portion of unsaleable products. E.g. A computer store
that still has a bunch of old Commodore 64 computers sitting in inventory.
the company has over-bought inventory (their inventory is way to large).
the value of the inventory has been overstated.
Too high an inventory turnover rate could also be concerning. It could mean:
the company has too small an inventory and are losing out on sales. E.g. if a donut shop
only keeps 1 donut on the shelf at a time, each time somebody purchases a donut, they
would have to make more. This would clearly result in lost sales.
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Investment Analysis
Financial Ratios

Pre-tax Cost of a Dividend

Formula:
Pre-tax Cost of a Dividend

Dividend
1 - Tax rate

What this ratio tells you:

When a company pays a dividend, it is not a tax-deductible expense, it is a sharing of the
profits. In other words, dividends are paid with after-tax dollars. This means to pay $1,000 in
dividends, the company actually has to earn more than $1,000 so when it pays tax on the
earnings, it still has enough left over to pay the $1,000 dividend.
What you will see in the exam question if they want you to use this formula
They will ask you what the pre-tax cost of a certain dividend is, given a stated tax rate.
Other things to know:
As you can see this chapter has many ratios to memorize. Using a process of elimination, you
can get the following question right even if you dont know the pre-tax cost of a dividend
formula. For example:
ABC Corp. is in a 40% tax bracket. What is the pre-tax cost of a $1,000 dividend?
a)
b)
c)
d)

$ 600
$1,000
$1,400
$1,667

Ask yourself the following questions:

If a company earned $600 and lost 40% to taxes, it would have 60% left over. Is 60% of $600
enough to pay a $1,000 dividend? Of course not, A is not the answer. Do that for all four
answers...
a)
b)
c)
d)

$ 600 x 60% = $360 (this is not enough!)

$1,000 x 60% = $600 (this is not enough!)
$1,400 x 60% = $840 (this is not enough!)
$1,667 x 60% = $1,000 (this is enough! The answer is D!)

Thank you for you interest in SeeWhy Financial Learning.

We sincerely hope that you will allow us to be a part of your CSC success!

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