Financial Ratios Cheat Sheet
You know how when someone tells you not to do something, you become more inclined to do it? Like you know you shouldn’t pick up that baby bird on the sidewalk, but you do anyway because it’s cute and you think yourself immune to all forms of avian viruses? Or like when your parents tell you to stop hitting your brother or sister, and then they turn around? Naturally you take one more shot before your parents disown you and take you out of the will. Well today I’m going to tell you not to do something, but give you the tools to do it anyway, in the form of this financial ratios cheat sheet… because I know the temptation can be too much sometimes…
In finance, there are lots of people that think they can beat the market. In fact, I’m sure most people think that they can beat the market. But for the most part… ok, honestly, it’s like 99.99% of people, are not going to be able to trade/invest any better than just using simple index funds. However, there are some that think they can use certain financial ratios to evaluate companies, and that’s what will give them the inside scoop on who to invest in. Really, it’s better to use these ratios to pick which companies NOT to invest in, but the information is yours to use as you will.
Keep in mind, this financial ratios cheat sheet should only be used to evaluate companies in a very surface-value way. Having 7 ratios does not give you a firm understanding of the entire valuation of a stock. Really, it’s just a way for you to filter out the garbage, if you choose to pick your own stocks. WHICH I DON’T EVER WANT YOU TO DO!!! But if you’re not going to listen to me, then the best thing I can do is prepare you for the fight…
Financial Ratios Cheat Sheet (feel free to share!)
Current Ratio – Beer
The Current ratio basically answers the question, “If everything falls to shit tomorrow, will the company be able to pay off its impending debts?” This is calculated by taking Current Assets (which can be found on the balance sheet of any 10-k) and dividing it by the Current Liabilities (also on the 10-k). Essentially, if the company had to use all its cash, sell its inventory, and make all its accounts receivable pay up, would they be able to pay all the debt that is due this year? If the number is greater than 1, the answer is yes. If it’s less than one, the answer is no.
So how is this like beer? Well, first off, it’s the staple of the ratios. This is one of the first financial ratios that any finance major should learn. Secondly, much in the way that too much beer isn’t a good thing, a current ratio that’s a lot higher than 1 isn’t a good thing. It means that there is a lot of cash that should be used for investment, or there’s a lot of inventory that still has yet to sell, or it has a TON of accounts receivable (which may or may not be paid). As long as the company is right around 1:1, without going too much over, you’ve got a good sign.
Price to Earnings (P/E) Ratio – Wine
Next on our Financial Ratios Cheat Sheet is the P/E Ratio, which is going to be a measure of value for the company. This financial ratio answers the question, “How much do I have to pay to get $1 of earnings?” Investors want to know this for this reason: suppose you have two companies, Bertha’s Bakery and Dan’s Department Store. If the P/E ratio for BB is 15:1, and the P/E ratio for DDS is 17:1, which do you think is the better investment (ALL ELSE BEING EQUAL!!! DON’T GET ALL ARGUMENTATIVE ON ME…)
Bertha’s Bakery is the better investment, because you’re only paying $15 for $1 of earnings, as opposed to $17. So how does this translate into wine?
Well, on the surface, wine is pretty simple. Get some grapes, stomp on them, throw them in a barrel with yeast, let it sit for a while, drink and make merry. But in the same way that there’s a ton that goes into determining what makes a wine good/bad/delicious/prohibitively expensive, P/E ratios have a lot going into them as well. For example, there are accountants that are paid millions upon millions of dollars per year to make that earnings number EXACTLY what the CEO and CFO want it to be. Yes, earnings numbers are easily manipulated, in the same way you’d manipulate temperature, humidity, grape type, altitude, and barrel wood to get a different wine.
Also, there are lots of variations on the P/E ratio, just like there are TONS of variations when it comes to wine. But if you’re looking for a single number to compare stocks, this might have to be on your list.
Return On Equity – Whiskey
A little heavier on the booze side, a little more complicated on the ratio side. Measuring ROE is as simple as taking the Net Income of a company and dividing it by the amount of equity in the business. However, this presents a couple of issues: there is more than one kind of equity, and there might be better measures of “money coming in” than net income. Again, a good accountant can manipulate these numbers to pretty much anything senior leadership wants.
ROE is a measure of efficiency, basically asking, “How much return (net income) can an investor expect for every dollar of investment (equity)?” This is important to know because investors will want to have some idea of what expected returns might look like if they choose to invest.
So, ROE is on our financial ratios cheat sheet as whiskey for two reasons: it’s a little complicated to understand, and it’s caused more than a couple fights between angry Irishmen… Ok, that last part’s not quite accurate. But it I’ve seen several discussions where the utility of ROE has been questioned rather heavily by both sides. Again, use it as a gauge, not an end-all, be-all financial ratio.
Debt/Equity Ratio – Tequila
Fourth on our financial ratios cheat sheet is the Debt to Equity Ratio. If you don’t know how to calculate this one just based off the name, then I fear there is less hope for you than the kid in 5th grade who SWORE that the Company that made Elmer’s glue also made milk… ick. Any who, taking the total debt and dividing it by the equity will give you the D/E ratio. Simple enough, right?
Debt/Equity Ratio is on the financial ratios cheat sheet because it gives an overall picture of how “leveraged” a company is. All that means is, “How much debt does a company have?” In general, the more debt a company has, the higher it’s returns will be when dealing with equity. This was an hour and a half long class in undergrad, so I’m not going to bore you with the details, but just trust me on it: debt increases expected returns. But it also increases risk (remember that relationship between risk and reward?). So this is a very subjective ratio: some investors will be looking for a higher ratio, while others (probably older, more conservative ones) will be looking for a small ratio.
Great, so now that I’ve given you more actual finance than you probably wanted, how does D/E ratio relate to Tequila? Well, tequila has two uses: forget something bad (like debt, or the fact that you lost your job, significant other, and sense of self all in the same week) and focus on the good stuff (like equity, closing a deal, or getting married…). Also, tequila is pretty simple to understand: take a couple shots, start to feel courageous, and watch your clothes melt off…
Operating Cash Flow/Sales – Vodka
Probably one of the best efficiency ratios on our financial ratios cheat sheet, OCF/Sales measures how well a company turns sales into profits. All other things being equal, you’d want a company that has a higher OCF/Sales than a lower OCF/Sales. This makes sense if you think about it: would you rather have a company that has a ton of sales, but can’t make a profit because of costs? Or would you rather a company that maybe has lower sales, but turns a profit every quarter.
Yeah, that’s what I thought.
OCF/Sales and Vodka, what have they got in common? OCF/Sales is what you’d use to see how efficiently a company is running. Vodka is what you’d use to efficiently get as blitzed as possible. BOOM! Efficiency equality…
Ok so this was a stretch. But I couldn’t have a listicle involving booze and NOT mention vodka…
Dividend Payout Ratio – Champagne
Payout… Champagne… I’m sure you see the trend here. The Dividend Payout ratio is going to be calculated by taking the total amount of dividends paid to investors, and dividing that by the total net income. This is the second subjective ratio on our financial ratio cheat sheet for this reason: there really is no “good” or “bad” ratio when it comes down to dividend payout. For example, small companies, which tend to be riskier, also tend to keep a lot of their income to reinvest back into R&D, Advertising, and other arms of the business that could help it grow. Large companies (think Coke) often pay out most of their income as dividends, because how much larger can Coke really get? (Dear Board of Directors at Coke, please don’t take that as a challenge. I don’t want to drive a Coke car or use a Coke computer…)
Why champagne? Because using the Dividend Payout ratio, we’re going to learn how much we’re getting paid! I can’t think of any better reason to celebrate!
Dividend Yield – Liqueur
My personal favorite, as well as trying to save the best for last, the Dividend Yield is the final ratio on our financial ratios cheat sheet. Simply put, the Dividend Yield is found by dividing the dividend per share by the price per share. This lets investors see how much they’re going to make in cash every year strictly from dividends. All else being equal, a higher dividend yield is better than a lower one. After all, who doesn’t want more cash?
I compared Dividend yield to liqueur for two reasons: you only get dividends four times a year, and when you do there’s really nothing SWEETER!!! Get it? I’m playing off the double meaning of the word “sweet”… like “sugary” and the more colloquial “good”…
Alright, clearly I’ve had a few too many while writing this… Let’s wrap it up…
Financial Ratios Cheat Sheet – The Wrap Up
So there are appropriate times to use this sheet, and times when it is not appropriate. If you’re just looking to screen some stocks and wanted a baseline understanding of how to do it, then this is a great reference for you. If you’re looking to become the next Warren Buffet or Carl Icahn, then you need a little bit more prep than this sheet. And for the love of god if you’re taking a test in your finance class don’t get caught with this thing. I don’t want to be the reason you get kicked out of school. Though at that point, I’d blame you for thinking this cheat sheet was actually supposed to be used for cheating… here’s what you need to know!
- Current Ratio – Current assets/ current liabilities. A very simple, easy to understand ratio, but can be too much of a good thing. When this number is high, it means that there’s capital available that’s not being used. May or may not be a red flag. Beer
- Price/Earnings Ratio – Price of Stock/Earnings per share. Used as a basic valuation ratio. Higher means an expensive stock, lower means a cheap one. Buyer beware, it’s up to you to determine which one is more appropriate for you. Wine
- Return on Equity – Net Income/ Total Shareholder Equity. This will allow you to see which company uses its equity better, for lack of better term. Causes a lot of fights, a lot of disagreement around this ratio. Whiskey
- Debt-Equity Ratio – Total Debt/ Total Shareholder equity. Literally just used to compare the two. The other subjective ratio on our financial ratios cheat sheet. Tequila
- Operating Cash Flow/Sales Ratio – OCF/Sales A great way to see how efficiently a company turns sales into cash, or “profit”. Vodka
- Dividend Payout Ratio – Total dividends paid/Net Income. Shows what percentage of income is allocated to going back to shareholders. Pop that bubbly, y’all… Champagne
- Dividend Yield – Dividend per share/price per share. How much you can expect to be paid in dividends per year. Liqueur
Any booze or ratio that you think I missed? Do you use these ratios to evaluate stocks, or do you use the index fund method like a sane person? What do you think the most important ratio is in evaluating a stock? Comment below!
Keep trying to crack the code,
Paul Andrews, Booze Connoisseur