Ratios to consider before investing

Debt to Equity Ratio. Debt to equity ratio is simply defined as total debt divided by total
equity. Liabilities are the portion of the companys capital financed by outsiders (bank loans,
etc.) whereas equities are the portion financed by the insiders or owners (shareholders). A
high debt to equity ratio means that the business rely heavily on debt in financing its
operations. If the business is not generating much revenue, the burden of interest expenses
on debts can seriously damage its health which can lead to bankruptcy. Generally, you
should look for LOW Debt to Equity Ratio.

Current Ratio. Current ratio is simply defined as current assets divided by current liabilities.
Current assets are generally liquid assets of the company. These assets are so-called
liquid because they are easily convertible to cash. Examples of current assets are cash,
inventory and accounts receivables.

For investors looking for businesses to buy, look for one with high current ratio. A high
current ratio indicates that the business has enough current or liquid assets to pay its
liabilities.
Quick Ratio. A more enhanced current ratio is the quick ratio. Quick ratio is simply defined
as current assets less inventory divided by current liabilities. This is taking into consideration
more liquid assets by taking out inventory. Inventory is excluded here since it might include
items that are difficult to liquidate quickly and that have uncertain liquidation values.

Cash Ratio. The best liquidity ratio is the cash ratio. It is simply defined by cash plus
marketable securities divided by current liabilities. Marketable securities are shares of the
company that is publicly listed. If the creditor of the company, i.e. a bank, demanded
payment anytime they want to, then this ratio is how fast can the company pay the bank.

Average Collection Period. A lot of times, businesses allow payment terms on their clients
especially companies providing supplies. Their clients can have their products but they can
pay on 30, 60 or even 90 days after. Average collection period is the way to gauge the
average days on how it takes a company to collect their accounts receivables from their
clients. It is defined as accounts receivables divided by average daily credited sales.
Credited sales mean that the proceeds of the sale are collected in the form of cash. You
should look for businesses that can collect accounts receivables as early as possible.

Gross Profit Margin. Gross profit margin is a ratio of profitability for every sales the
company generates. It is simply defined as sales less cost of goods sold divided by sales.
We all know that before companies can produce a certain product, they need to encounter
some DIRECT costs such as expenses used to purchase raw materials and labor costs.
Cost of goods sold pertains to direct expenses that the company has for every product they
produce. However, it EXCLUDES INDIRECT costs such as sales commission of agents, etc.
If you are eyeing a business to purchase, then you must look for high gross profit margin.

Return on Assets. A business may have a lot of assets in its possession. However, these
assets may become idle because they are not being utilized to generate profits. An example
of this is the company may have purchased a real estate, say a warehouse, but it is not
being used. Therefore, it could be subject for devaluation if no further improvement is made
on its location and termites and rust eat the warehouse itself as time passes by.
Return on assets is a measure of how effectively the companys assets are being used to
generate profits. It is defined by net income divided by total assets. When youre buying a
business, always look for a higher return on assets. Theres no use even if the company has
a lot of assets if its not being used to generate profits.

In addition, there are two other important measures of how profitable a business is. These
are working capital and net income.
Working Capital. Working capital is not much of a ratio but it gives you an idea of the
cashflow of the company. It is defined as total current assets minus total current liabilities.
The result of this calculation must be a positive number.
Net Income/Earnings. Finally, one of the most important gauge is the net income. It
pertains as to how much the business is making. It is defined by total revenues minus total
expenses.
In accounting, there are other financial ratios out there but for me, here are the most
important ratios that you should know when buying a business.
Furthermore, you should be comparing these ratios on a year to year level. Generally, if you
want to buy a business, an increasing net income year over year is the best gauge.

Earnings per share: Before you can understand many of these ratios it is important to learn
what earnings per share (EPS) is. EPS is basically the profit that a company has made over
the last year divided by how many shares are on the market. It gets a little more complicated
because you don't include preferred shares, also the number of shares could change
throughout the year.

Also important to investing decisions is the rate that a company is expected to pay on
average to all its security holders to finance its assets. This is what we call Weighted
Average Cost of Capital (WACC). This will be detailed below.

Weighted Average Cost of Capital

In a broad sense, a company finances its assets either through debt or with equity. WACC is
the average of the costs of these types of financing, each of which is weighted by its
proportionate use in a given situation. By taking a weighted average in this way, we can
determine how much interest a company owes for each dollar it finances.
Debt and equity are the two components that constitute a companys capital funding.
Lenders and equity holders will expect to receive certain returns on the funds or capital they
have provided. Since cost of capital is the return that equity owners (or shareholders) and
debt holders will expect, so WACC indicates the return that both kinds of stakeholders
(equity owners and lender) can expect to receive. Put another way, WACC is an investors
opportunity cost of taking on the risk of investing money in a company.
A firm's WACC is the overall required return for a firm. Because of this, company Board of
Trustees will often use WACC internally in order to make decisions, like determining the
economic feasibility of a merger and other expansionary opportunities. WACC is the
discount rate that should be used for cash flow with risk that is similar to that of the overall
firm.
To help understand WACC, try to think of a company as a pool of money. Money enters the
pool from two separate sources: debt and equity. Proceeds earned through business
operations are not considered a third source because, after a company pays off debt, the
company retains any leftover money that is not returned to shareholders (in the form of
dividends) on behalf of those shareholders.
Suppose that lenders requires a 10% return on the money they have lent to a firm, and
suppose that shareholders require a minimum of a 20% return on their investments in order
to retain their holdings in the firm. On average, then, projects funded from the companys
pool of money will have to return 15% to satisfy debt and equity holders. The 15% is the

WACC. If the only money in the pool was $50 in debt holders contributions and $50 in
shareholders investments, and the company invested $100 in a project, to meet the lenders
and shareholders return expectations, the project would need to generate returns of $5 each
year for the lenders and $10 a year for the companys shareholders. This would require a
total return of $15 a year, or a 15% WACC.

Uses of Weighted Average Cost of Capital (WACC)

Analysts frequently use WACC when assessing the value of investments and when
determining which ones to pursue. For example, in discounted cash flow analysis, one may
apply WACC as the discount rate for future cash flows in order to derive a business's
present value. WACC may also be used as a hurdle rate against which to gauge ROIC
performance. WACC is also essential in order to perform economic value added (EVA)
calculations.
Investors may often use WACC as an indicator of whether or not an investment is worth
pursuing. Put simply, WACC is the minimum acceptable rate of return at which a company
yield returns for its investors. To determine an investors personal returns on an investment
in a company, simply subtract the WACC from the companys returns percentage. For
example, suppose that a company yields returns of 20% and has a WACC of 11%. This
means the company is yielding 9% returns on every dollar the company invests. In other
words, for each dollar spent, the company is creating nine cents of value. On the other hand,
if the company's return is less than WACC, the company is losing value. If a company has
returns of 11% and a WACC of 17%, the company is losing six cents for every dollar spent,
indicating that potential investors would be best off putting their money elsewhere.
WACC can serve as a useful reality check for investors; however, the average investor
would rarely go to the trouble of calculating WACC because it is a complicated measure that
requires a lot of detailed company information. Nonetheless, being able to calculate WACC
can help investors understand WACC and its significance when they see it in brokerage
analysts' reports.

Limitations of Weighted Average Cost of Capital (WACC)

The WACC formula seems easier to calculate than it really is. Because certain elements of
the formula, like cost of equity, are not consistent values, various parties may report them
differently for different reasons. As such, while WACC can often help lend valuable insight
into a company, one should always use it along with other metrics when determining whether
or not to invest in a company.

Calculation and practical example

Here is the basic formula for weighted average cost of capital:

WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)]

E = Market value of the company's equity

D = Market value of the company's Debt
V = Total Market Value of the company (E + D)
Re = cost of equity
Rd = Cost of Debt
T= tax rate
A company is typically financed using a combination of debt (bonds) and equity
(shares/stock). Because a company may receive more funding from one source than
another, we calculate a weighted average to find out how expensive it is for a company to
raise the funds needed to buy buildings, equipment, and inventory.
Practical example:
Assume newly formed company ABC needs to raise $1 million in capital so it can buy office
buildings and the equipment needed to conduct its business. The company issues and sells
6,000 shares of stock at $100 each to raise the first $600,000. Because shareholders expect
a return of 6% on their investment, the cost of equity is 6%.
Corporation ABC then sells 400 bonds for $1,000 each to raise the other $400,000 in capital.
The people who bought those bonds expect a 5% return, so ABC's cost of debt is 5%.
Corporation ABC's total market value is now ($600,000 equity + $400,000 debt) = $1 million
and its corporate tax rate is 35%. Now we have all the ingredients to calculate Corporation
ABC's weighted average cost of capital (WACC).
WACC = (($600,000/$1,000,000) x 0.06) + [(($400,000/$1,000,000) x 0.05) * (1-0.35))] = 0.049 =
4.9%

Corporation ABC's weighted average cost of capital is 4.9%.

This means for every $1 Corporation ABC raises from investors, it must pay its investors
almost $0.05 in return.

Why it Matters:
It's important for a company to know its weighted average cost of capital as a way to gauge
the expense of funding future projects. The lower a company's WACC, the cheaper it is for a
company fund new projects.
A company looking to lower its WACC may decide to increase its use of cheaper financing
sources. For instance, company ABC may issue more bonds instead of shares/stock
because it can get the financing more cheaply. Because this would increase the proportion
of debt to equity, and because the debt is cheaper than the equity, the company's weighted
average cost of capital would decrease.

References:
Financial Ratios You Need to Know When Buying a Business. (2009, November 14).
Retrieved October 2, 2015, from http://www.millionaireacts.com/1934/financial-ratiosyou-need-to-know-when-buying-a-business.html
8 Simple Investing Ratios You Need To Know - Slideshow | Investopedia. (2010,
August 5). Retrieved October 2, 2015, from http://www.investopedia.com/slideshow/simple-ratios/
Weighted Average Cost of Capital (WACC) Definition | Investopedia. (2003, November
18). Retrieved October 2, 2015, from http://www.investopedia.com/terms/w/wacc.asp
Weighted Average Cost of Capital (WACC). (2015). Retrieved October 2, 2015, from
http://www.investinganswers.com/financial-dictionary/financial-statementanalysis/weighted-average-cost-capital-wacc-2905