How Finance Works

Financial ratios help make meaningful comparisons across companies through time.

Liquidity ratios measure the risk that a company will go bankrupt. If you're going to do business with a company, you'll want to know whether it can pay suppliers. For shareholders, a good liquidity ratio ensures the company doesn't go bankrupt.

There are two major types:

1. Current Ratio
2. Quick Ratio

Current Ratio = Current Assets / Current Liabilities

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

Why exclude inventory? For finance people, inventory is a risk. Think of companies like Blackberry and Burberry. If something goes wrong with their inventory, there is no spot market for that product and the inventory can go obsolete.

1. Profit Margin = Net Profit / Revenue
2. Return on Equity (ROE) = Net Profit / Shareholders Equity
3. Return on Assets (ROA) = Net Profit / Assets
4. EBITDA Margin = EBITDA / Revenue

• Depreciation refers to how physical assets such as vehicles and equipment lose value over time
• Amortization refers to the same phenomenon but for intangible assets

1. Magnify earnings (think of the house example—mortgage lets you benefit from full appreciation)
2. Helps you get control of assets you have no right to control

Debt to Capitalization Ratio = Debt / (Debt + Shareholders Equity)

Interest Coverage Ratio = EBIT / Interest Expense

LBO stands for Leveraged Buyout. In this transaction, the company borrows to buy out many shareholders, leaving it much more highly leveraged.

Good LBO candidates:

• Companies with stable business models and committed customers
• Classic targets include tobacco companies, gaming companies, and utilities because of their committed customers and predictable demand

Asset Turnover Ratio = Revenue / Assets

It measures how effective the company is at using its assets to generate revenue.

Inventory Turnover = Cost of Goods Sold / Inventory

• Measures how many times a company turns over or sells all its inventory in a given year
• The higher the number, the more effective the company is at managing inventory as it sells products
• Remember: inventory is considered a risky asset in finance, so a high turnover ratio is financially valuable

Days Inventory = 365 / Inventory Turnover

Examples:

• If a company has days inventory of 30, it turns its inventory more than 30 times a year—inventory sticks around for slightly more than 10 days
• If a company has turnover of only 4 times a year, inventory sticks around for almost 100 days

1. It includes the effects of leverage
2. It does not measure operational performance

1. Conservatism – For example, Apple's goodwill/brand has no value on the balance sheet
2. Accrual accounting – Revenue recognition doesn't always match cash flows

EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortization

Method 1: Working Capital = Current Assets - Current Liabilities

Method 2: Working Capital = Accounts Receivable + Inventories - Accounts Payable

Working capital is the daily operation of the company that needs to be financed.

Key insight: If a company has lower working capital needs, it has lower financing needs and therefore a lower cost of capital.

1. Companies hold inventory longer
2. Customers cannot pay contractors faster
3. Recession increases days in collection periods
4. Since banks were recoiling, there was no way to finance those gaps