Q-1 Profitability Ratios Profitability is a key piece of information that should be analyzed when you're considering investing in a company.

This is because high revenues alone don't necessarily translate into dividends for investors (or increased stock prices, for that matter) unless a company is able to clear all of its expenses and costs. Profitability ratios are used to give us an idea of how likely it is that a company will turn a profit, as well as how that profit relates to other important information about the company. One example of an important profitability ratio is the profit margin. The profit margin is calculated as follows:

In general, the higher a company's profit margin the better but, as with most ratios, it is not enough to look at it in isolation. It is important to compare it to the company's past levels, to the market average and to its competitors. There are a couple of red flags you should watch out for with the profit margin, especially where the company is seeing decreasing profit margins year over year. This can suggest changing market conditions or where the company is seeing increasing competition or rising costs. Also, if a company's profit margin is out of line compared to the rest of its industry, it is worth the extra effort to find out why. If a company has a really low profit margin, it could mean the company will land in a bad position if market conditions change. A really high profit margin relative to an industry could mean that the company has arrangements or advantages that might not last.

Liquidity Ratios Liquidity is a measure of how quickly a company's assets can be converted to cash. Liquidity ratios can give investors an idea of how capable a company will be at raising cash to purchase additional assets or to repay creditors quickly, either in an emergency situation, or in the course of normal business. The receivables turnover ratio is a liquidity ratio that measures a company's ability to collect on debts and accounts owed to them. Receivables turnover is calculated as follows:

This ratio represents the number of times in the period that the payments owed to a company will be collected. If you divide 365 by the receivables turnover ratio, you will find the average number of days that it takes a company to collect on receivables, or the number of days between the time it takes a company to make a credit sale and the time that it receives a cash payment.. In the case of this ratio, a higher number means that the company collects more frequently (good liquidity), whereas a low ratio may mean that clients are not paying up in a timely manner. Like most ratios, the true value of the information isn't really there unless you make a comparison across the industry. Other liquidity ratios include working capital turnover, inventory turnover and current ratio. (To continue reading on liquidity, see Do Your Investments Have Short-Term Health?, Working Capital Works and Inventory Valuation For Investors: FIFO And LIFO.) Solvency Ratios Solvency ratios are used by investors to get a picture of how well a company can deal with its longterm financial obligations and develop future assets. As you might expect, a company weighed down with debt is probably a less favorable investment than one with a minimal amount of debt on its books. The total debt to total assets ratio is used to determine how many of a company's assets were paid for with debt. Total debt to total assets is calculated as follows:

When using this ratio to make an analysis of a company, it can be really helpful to look at the company's as well as making industry comparisons. It's not unrealistic for a younger company to have a debt to total assets ratio closer to "1" (more assets were financed by debt), as it hasn't yet had a chance to eliminate its debt. As a general rule, a number close to zero is generally better, because it means that more assets were paid for without debt. Remember, lenders have first claim on a company's assets if they're forced to liquidate. But again, it will depend on the industry, as those with highly capital intensive operations will have a higher relative debt level.

Valuation Ratios Valuation ratios are used to analyze the attractiveness of an investment in a company. The idea is that by using these ratios investors can gain an understanding of how cheap or expensive a company company's current stock price is compared to several different measures. In general, the less expensive a company is, the more attractive an investment in that company becomes. The price to earnings (P/E) ratio is the most well-known valuation ratio that compares the company's stock price to the amount of earnings it generates on a per-share basis. An easy way to think about the P/E ratio is that it's a pretty good indicator of investors' expectations of a company's future income. That is, it's the premium that the market is willing to pay for a particular security's earnings. The P/E ratio is calculated as follows:

The ratio can be compared to past levels for the company along with industry competitors and the overall market. It transforms any company's earnings into an easily comparable measure. Basically, it will tell you how much an investor are willing to pay for $1 of earnings in that company - the higher the ration, the more they are willing to spend. But don't think that a higher P/E ratio for one company necessarily suggests that its stock is overpriced. Different industries have substantially different P/E ratios, so the P/E really shouldn't be used for inter-industry comparisons. (To continue reading about the P/E, see Understanding The P/E Ratio, Move Over P/E, Make Way For The PEG and Are lower P/E ratio stocks always better investments?)

Valuation Ratios for Investment Analysis

By Peter J. Sander and Janet Haley With valuation ratios, a company's stock price enters your investment analysis. Valuation ratios include the everpopular price to earnings (P/E) ratio, along with price to sales (P/S), price to book (P/B), and a couple of boutique P/E variations.

Price to earnings
Price to earnings (P/E) is just what it sounds like: the ratio of a price at a point in time to net earnings in a period, usually the trailing 12 months (TTM). Here's the formula: Price to earnings (P/E) = stock price / net earnings per share A high P/E, say 20 or higher, indicates a relatively high valuation; a low P/E, say 15 or less, indicates a relatively low or more conservative one.

Earnings to price
Earnings to price, a deriviative of P/E, is simply the reciprocal of P/E, or 1 divided by the P/E. Why is this important? Earnings to price is the functional equivalent of a stock's yield, comparable to an interest rate on a fixed income investment. Because we're talking earnings and not dividends, this yield doesn't usually come your way in the form of a check, but it's useful just the same to determine how much return your dollar paid for a share is generating. Many people call this figure earnings yield.

Price/earnings to growth

When comparing businesses, one popular way to "normalize" P/Es is to compare them to their respective company's growth rate. From this comparison, get to know another derivative of P/E,price/earnings to growth, or PEG: Price/earnings to growth (PEG) = (P/E) / earnings growth rate The lower the PEG, the better. But if the low PEG is driven by high growth rates, you'd better be confident in the growth rate assumption.

Price to sales
Per dollar of shareholder value, how much business does this company generate? Price to sales (P/S) is a straightforward way to answer this question. Here's the formula: Price to sales (P/S) = stock price (total market cap) / total sales (revenues) P/S is a common-sense ratio: The lower the better, although there's no specific rule or normalizing factor like growth. Somewhere around 1.0 is usually considered good. Don't read too much into the raw P/S number, especially when comparing companies in different industries. A company selling big-ticket items may have a very low P/S ratio. Ford Motor is an example, at 0.11. But low margins and high expenses reduce the profitability of those sales; Cisco, on the other hand, has much higher margins.

Price to book
The price to book (P/B) ratio is getting varying amounts of attention from investors in different sectors: Price to book (P/B) = stock price (total market cap) / book value Book value consists of the accounting value of assets less (real) liabilities sort of an accounting net worth or owner's equity of a corporation. This figure has greater meaning in financial services industries, where most assets are actual dollars, not factories, inventories, and other hard-to-value items.

Q-5
Drawbacks & limitations of ratio analysis Ratio analysis is widely used in practice in business. Teams of investment analysts pour over the historical and forecast financial information of quoted companies using ratio analysis as part of their toolkit of methods for assessing financial performance. Venture capitalists and banker use the ratios featured here and others when they consider investing in, or loaning to businesses. The main strength of ratio analysis is that it encourages a systematic approach to analysing performance. However, it is also important to remember some of the drawbacks of ratio analysis

Ratios deal mainly in numbers they dont address issues like product quality, customer service, employee morale and so on (though those factors play an important role in financial performance) Ratios largely look at the past, not the future. However, investment analysts will make assumptions about future performance using ratios Ratios are most useful when they are used to compare performance over a long period of time or against comparable businesses and an industry this information is not always available

Financial information can be massaged in several ways to make the figures used for ratios more attractive. For example, many businesses delay payments to trade creditors at the end of the financial year to make the cash balance higher than normal and the creditor days figure higher too.

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Definition of 'Cash Flow'

1. A revenue or expense stream that changes a cash account over a given period. Cash inflows usually arise from one of three activities - financing, operations or investing - although this also occurs as a result of donations or gifts in the case of personal finance. Cash outflows result from expenses or investments. This holds true for both business and personal finance. 2. An accounting statement called the "statement of cash flows", which shows the amount of cash generated and used by a company in a given period. It is calculated by adding noncash charges (such as depreciation) to net income after taxes. Cash flow can be attributed to a specific project, or to a business as a whole. Cash flow can be used as an indication of a company's financial strength.

Investopedia explains 'Cash Flow'

1. In business as in personal finance, cash flows are essential to solvency. They can be presented as a record of something that has happened in the past, such as the sale of a particular product, or forecasted into the future, representing what a business or a person expects to take in and to spend. Cash flow is crucial to an entity's survival. Having ample cash on hand will ensure that creditors, employees and others can be paid on time. If a business or person does not have enough cash to support its operations, it is said to be insolvent, and a likely candidate for bankruptcy should the insolvency continue. 2. The statement of a business's cash flows is often used by analysts to gauge financial performance. Companies with ample cash on hand are able to invest the cash back into the business in order to generate more cash and profit.

Q-7 Limitations of the cash flow statement

Cash flow statements should normally be used in conjunction with income statements and balance sheets when making an assessment of future cash flows.

Cash flow statements are based on historical information and therefore do not provide complete information for assessing future cash flows. There is some scope for manipulation of cash flows. For example, a business may delay paying suppliers until after the year-end, or it may structure transactions so that the cash balance is favourably affected. It can be argued that cash management is an

important aspect of stewardship and therefore desirable. However, more deliberate manipulation is possible.

Cash flow is necessary for survival in the short term, but in order to survive in the long term a business must be profitable. It is often necessary to sacrifice cash flow in the short term in order to generate profits in the long term. A huge cash balance is not a sign of good management if the cash could be invested elsewhere to generate profit.

Neither cash flow nor profit provide a complete picture of a companys performance when looked at in isolation

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