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Investing - Financial Ratio
To determine the viability of a company can be a lengthy and complex process. A quick way to narrow down the selection process would be to evaluate the financial strength of the company and the effectiveness of its management team.
Financial ratio consisting of current ratio, debt-equity ratio, price-earning ratio (PER) and return on equity (ROE) is one quick way to check the status of a company.
Current Ratio
Current Ratio is an indicator of the company's debt-paying ability over the short term (12 months or less). It's determined by dividing the current assets by the current liabilities. If the outcome is between 1 and 2.5, the company's financial situation can be considered as healthy. Even tough, the higher the ratio, the more liquid the company, however, anything over 2.5 would indicate that the company may be keeping too much cash and may not be investing enough to provide future growth.
It's probably also useful at this point to calculate the interest coverage ratio, which will indicate the company's ability to service its debt. Interest coverage ratio is income before interest and tax divided by the interest expense. The greater coverage, the better it is.
Debt-To-Equity Ratio
Debt-To-Equity Ratio is an indicator of a company's long term financial leverage. It compares the assets provided by the creditors with the assets provided by the shareholders of the company and is determined by dividing the long term debt by the shareholder's equity.
The track record of the management team can be determined by using the following ratios:
Price-Earnings-Ratio (PER)
The Price-Earnings-Ratio is the relationship between the market price of the company's shares and the earnings per share (EPS). This ratio tells you what you would be paying for each dollar of earnings. To work out the PER; divide the share price by the EPS. Generally, a high PER would means high projected earnings in the future. However the PER actually doesn't tell us a whole lot by itself. It's useful to compare the PER of companies in the same industry, or to the market in general, or against the company's own historical PER.
As earnings tend to fluctuate from year to year, consider using the average earnings over the last six to ten years rather than for a particular year. It's more valuable to look at the PER over time in order to determine the trend.
Return On Equity (ROE)
The Return On Equity encompasses the three main areas where investors can assess the company's profitability, asset management and financial leverage. ROE represents the management's ability to balance these three pillars of corporate management and investors will get a feel of whether they'll receive a reasonable return on equity and assess the management's ability to perform.
ROE is determined by dividing net income by shareholders' equity. Net income is the last item listed on the income statement while shareholders' equity (the difference between total assets and total liabilities which is located in the balance sheet).
By working out these ratios, investors are able to form an evaluation of a company's financial strength, its management and employees. However, these ratios should only be used as a guide only. They should also be viewed in conjunction with each individual's objective.
For instance, if you were a value investor, you would consider a company with a PER of 30 to be too expensive. However, if you were going for growth, you would consider the company to be viable investment if it had an ROE of over 25 and its earnings were still growing rapidly.
| Michael Russell Your Independent guide to Investing Article Source: http://EzineArticles.com/?expert=Michael_Russell | |
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Many investors have bad habits: taking too much or too little risk in their long-term investments; panicking and selling following a large market drop; and chasing returns by buying last year's winners. The study of "Behavioral Finance" provides insight into why investors so often make expensive mistakes... and then make them over and over again. The study of how psychology affects finance lays out some logical explanations for otherwise irrational behavior.
In his book, Beyond Greed and Fear (Harvard Business School Press, 1999), author Hersh Shefrin describes common patterns in investor behavior. A principle behavior, he states, is that investors rely on rules of thumb, or judgments based on stereotypes.
Beware the Rule of Thumb
Traditional finance assumes that investors will make objective decisions based on unbiased data. In contrast, behavioral finance asserts that investors often rely on rules of thumb to make their decisions. Because these rules of thumb may be inaccurate, investors end up making bad decisions.
The classic faulty rule of thumb is the belief that past performance is the best indicator of future performance. Subscribers to this fallacy chase hot funds in the mistaken belief that performance over a period as short as a year indicates that a fund manager is skilled, not lucky.
Here are some more flawed rules of thumb:
Losers keep losing. If a stock in your portfolio goes down, sell it;
- Winners keep winning. Buy more of the stocks that are going up;
- Small cap stocks and foreign stocks are too risky for the average investor;
- There are stock pickers who consistently beat the market
- There are fund managers who consistently beat the market
Operating with rules of thumb like these makes it all but impossible to construct a strong portfolio, or to properly maintain it. Perhaps the most common mistake investors make is simply trading too much. They believe that investing means trying to pick the winners, and they try with great vigor.
Academic studies tell us, however, that frequent traders generally earn mediocre returns. One study was conducted by Brad Barber and Terrance Odean ("Trading is Hazardous to Your Wealth," The Journal of Finance, April 2000). The authors looked at the trading histories of more than 66,000 investors over six years ending in 1996. They found that those that traded the most had the worst returns.
In fact, the most active traders earned average annual returns of 11.4%, while the overall market return was 17.9%. How much is that difference worth in dollar terms? Applied to a starting balance of $100,000, the lower return would cost you $77,464 over six years.
Why do investors engage in this kind of destructive behavior? Cognitive dissonance is one reason. People tend to see evidence that confirms their beliefs, while dismissing evidence to the contrary. An active investor earning an 11.4% return might conclude that she did well because her accounts grew. She ignores evidence of how much more she could have earned with a simple buy-and-hold strategy, and may even consider those who got the higher return of being greedy.
Keeping on Track
We recommend three important guidelines to avoid making common behavioral investing mistakes:
1. Create a long-term plan - and stick with it. A sound investment plan will maximize the probability of achieving your most important financial goals. The plan should spell out your long-term needs, objectives and values; define risk tolerance; establish a time horizon; determine rate-of-return objectives; describe the asset classes and investment methodology that will be used, and establish a strategic implementation plan.
The plan should be monitored and adjusted based on changes in your personal economic status or goals. Market fluctuations, hot tips, and forecasts should never drive your plan.
2. Look at the big picture. Always put performance in perspective. Individual investments should be examined not just in context of overall market returns, but also as part of the larger performance over time. The goal is to capture full market returns over a long period. You may not have positive results every quarter, but you will still be on track to achieve your financial goals.
3. Keep your costs low. Your goal should be to implement and maintain your strategy at the lowest possible cost. There are many no-load, low-fee funds out there, so why spend more on a high-fee fund?
Northstar Financial Planners is a fee-only investment advisor, devoted to a structured asset class investment strategy. Allen Giese has been a financial advisor for over 17 years, working with professionals, business owners, executives and retirees. He is founder and President of Northstar Financial Planners, Inc. Prior to founding Northstar, Allen had worked in the securities and insurance industry, working as an agent and representative. He has also owned businesses in the retail sector and was a professional violinist, having received his degree from the University of Miami in violin performance. He continues to play music with his musical friends.
Article Source: http://EzineArticles.com/?expert=Allen_Giese
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