Capital Markets PDF

I. CAPITAL MARKETS A. Stock Markets The stock market is where the prices of firms’ stocks are established. Because the primary goal of financial managers is to maximize their firms’ stock prices, knowledge of the stock market is important to anyone involved in managing a business. 2 Basic Types...

I. CAPITAL MARKETS A. Stock Markets The stock market is where the prices of firms’ stocks are established. Because the primary goal of financial managers is to maximize their firms’ stock prices, knowledge of the stock market is important to anyone involved in managing a business. 2 Basic Types of Market Procedures: 1. Physical Location Stock Exchanges - Formal organizations having tangible physical locations that conduct auction markets in designated (“listed”) securities. - Physical location exchanges are tangible entities. Each of the larger exchanges occupies its own building, allows a limited number of people to trade on its floor, and has an elected governing body – its board of governors. 2. Over-The-Counter (OTC) - A large collection of brokers and dealers, connected electronically by telephones and computers, that provides for trading in unlisted securities. - Although the stocks of most large companies trade on the NYSE, a larger number of stocks trade o_ the exchange in what was traditionally referred to as the over- the-counter (OTC) market. Dealer Markets – A dealer market includes all facilities needed to conduct security transactions, but the transactions are not made on the physical location exchanges. The dealer market system consists of: 1. The relatively few dealers who hold inventories of these securities and who are said to "make a market" in these securities; 2. The thousands of brokers who act as agents in bringing the dealers together with investors; and 3. The computers, terminals, and electronic networks that provide a communication link between dealers and brokers. B. Equity Valuation The main purpose equity valuation is to estimate the value of a firm or its security. A key assumption of any fundamental value technique is that the value of the security (in this case an equity or a stock) is driven by the fundamentals of the firm’s underlying business at the end of the day. There are a number of di_erent methods of valuing a company with one of the primary ways being the comparable (or comparables) approach. Comparables Approach. A company’s equity value should bear some resemblance to other equities in a similar class. This entails comparing a company’s equity to competitors or other firms in the same sector.  Discounted Cash Flow. A company’s equity value is determined by the future cash flow projections using net present value. This approach is most useful if the company has strong data to support future operating forecasts. Precedent Transactions. A company’s equity depends on historical prices for completed M&A transactions involving similar companies. This approach is only relevant if similar entities have been recently valued and/or sold. Asset-Based Valuation. A company’s equity value is determined based on the fair market value of net assets owned by the company. This method is most often used for entities with a going concern, as this approach emphasizes outstanding liabilities determining net asset value. Book-Value Approach. A company’s equity value is determined based on its previous acquisition cost. This method is only relevant for companies with minimal growth that might have undergone a recent acquisition. C. Capital Structure The term capital refers to investor-supplied funds—debt, preferred stock, common stock, and retained earnings. Accounts payable and accruals are not included in our definition of capital because they are not provided by investors—they come from suppliers, workers, and taxing authorities as a result of normal operations, not as investments by investors. A firm’s capital structure is typically defined as the percentage of each type of investor- supplied capital, with the total being 100%. The optimal capital structure is the mix of debt, preferred stock, and common equity that maximizes the stock’s intrinsic value. The capital structure that maximizes the intrinsic value also minimizes the weighted average cost of capital (WACC). II. BEHAVIORAL FINANCE Behavioral Finance is the study of various psychological factors that can a_ect financial markets. Behavioral finance typically encompasses five main concepts: Mental accounting: Mental accounting refers to the propensity for people to allocate money for specific purposes. Herd behavior: Herd behavior states that people tend to mimic the financial behaviors of the majority of the herd. Herding is notorious in the stock market as the cause behind dramatic rallies and sell-o_s. Emotional gap: The emotional gap refers to decision-making based on extreme emotions or emotional strains such as anxiety, anger, fear, or excitement. Oftentimes, emotions are a key reason why people do not make rational choices. Anchoring: Anchoring refers to attaching a spending level to a certain reference. Examples may include spending consistently based on a budget level or rationalizing spending based on di_erent satisfaction utilities. Self-attribution: This refers to a tendency to make choices based on overconfidence in one’s own knowledge or skill. Self-attribution usually stems from an intrinsic knack in a particular area. Within this category, individuals tend to rank their knowledge higher than others, even when it objectively falls short. A. Emotion and Investing Some Biases Revealed by Behavioral Finance. Breaking down biases further, many individual biases and tendencies have been identified for behavioral finance analysis. Some of these include: Confirmation Bias o Confirmation bias is when investors have a bias toward accepting information that confirms their already-held belief in an investment. If information surfaces, investors accept it readily to confirm that they’re correct about their investment decision-even if the information is flawed. Experiential Bias o This occurs when investors’ memory of recent events makes them biased or leads them to believe that the event is far more likely to occur again. For this reason, it is also known as recency bias or availability bias. Loss Aversion o Loss aversion occurs when investors place a greater weighting on the concern for losses than the pleasure from market gains. In other words, they’re far more likely to try to assign a higher priority to avoiding losses than making investment gains. As a result, some investors might want a higher payout to compensate for losses. If the high payout isn’t likely, they might try to avoid losses altogether even if the investment’s risk is acceptable from a rational standpoint. Familiarity Bias  o The familiarity bias is when investors tend to invest in what they know, such as domestic companies of locally owned investments. As a result, investors are not diversified across multiple sectors and types of investments, which can reduce risk. Investors tend to go with investments that they have a history or have familiarity with. B. Behavioral Finance and Investment Strategy Market Timing and Technical Analysis Asset bubbles and market crashes are largely a matter of timing. If you could anticipate a bubble and invest just before it began and divest just before it burst, you would get maximum return. That sort of precise timing, however, is nearly impossible to achieve. To time events precisely, you would constantly have to watch for new information, and even then, the information from di_erent sources may be contradictory, or there may be information available to others that you do not have. Taken together, your chances of profitably timing a bubble or crash are fairly slim. Market timing – an asset allocation strategy. C. Behavioral Finance and Capital Markets The e_icient market hypothesis (EMH) says that at any given time in a highly liquid market, stock prices are e_iciently valued to reflect all the available information. However, many studies have documented long-term historical phenomena in securities markets that contradict the e_icient market hypothesis and cannot be captured plausibly in models based on perfect investor rationality. The EMH is generally based on the belief that market participants view stock prices rationally based on all current and future intrinsic and external factors. When studying the stock market, behavioral finance takes the view that markets are not fully e_icient. This allows for the observation of how psychological and social factors can influence the buying and selling of stocks. The understanding and usage of behavioral finance biases can be applied to stock and other trading market movements on a daily basis. Broadly, behavioral finance theories have also been used to provide clearer explanations of substantial market anomalies like bubbles and deep recessions. While not a part of EMH, investors and portfolio managers have a vested interest in understanding behavioral finance trends. These trends can be used to help analyze market price levels and fluctuations for speculation as well as decision-making purposes. III. INTEREST RATES Companies raise capital in two main forms: debt and equity. In a free economy, capital, like other items, is allocated through a market system, where funds are transferred and prices are established. The interest rate is the price that lenders receive, and borrowers pay for debt capital. Similarly, equity investors expect to receive dividends and capital gains, the sum of which represents the cost of equity. A. The Determinants of Market Interest Rates o The Real Risk-Free Rate of Interest, R* - the rate of interest that would exist on default- free US Treasury if no inflation were expected. o The Nominal, or Quoted, Risk-Free Rate of Interest – the rate of interest on a security that is free of all risk; rRF is proxied by the T-bill rate or the T-bond rate; rRF includes an inflation premium. o Inflation Premium (IP) – a premium equal to expected inflation that investors add to the real risk-free rate of return. o Default Risk Premium (DRP) – the di_erence between the interest rate on a US Treasury bond and a corporate bond of equal o Liquidity Premium (LP) – a premium added to the equilibrium interest rate on a security if that security cannot be converted to cash on short notice and at close to its “fair market value.” o Interest Rate Risk – the risk of capital losses to which investors are exposed because of changing interest rates. o Maturity Rate Premium – a premium that reflects interest rate risk. o Reinvestment Rate Risk – the risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested. The Cost of Money 4 Most Fundamental Factors A_ecting the Cost of Money: 1. Production Opportunities – The investment opportunities in productive (cash- generating) assets. 2. Time Preferences for Consumption – The preferences of consumers for current consumption as opposed to saving for future consumption. 3. Risk – In a financial market context, the chance that an investment will provide a low or negative return. 4. Inflation – The amount by which prices increase over time. People use money as a medium of exchange. When money is used, its value in the future, which is a_ected by inflation, comes into play. The higher the expected rate of inflation, the larger the required dollar return. Interest rate paid to savers depends on: (1) the rate of return that producers expect to earn on invested capital (2) savers’ time preferences for current versus future consumption  (3) the riskiness of the loan, and (4) the expected future rate of inflation. Producers’ (borrowers) expected returns on their business investments set an upper limit to how much they can pay for savings, while consumers’ time preferences for consumption establish how much consumption they are willing to defer and hence how much they will save at di_erent interest rates. Higher risk and higher inflation also lead to higher interest rates. Interest Rate Levels Short-term rates are responsive to current economic conditions. Long-term rates primarily reflect long-run expectations for inflation. Term Structure of Interest Rates – the relationship between long-term and short-term rates. Term Structure of Interest Rates - The relationship between bond yields and maturities. - It describes the relationship between long- and short-term rates. - The term structure is important to corporate treasurers deciding whether to borrow by issuing long- or short-term debt and to investors who are deciding where to buy long- or short-term bonds. Yield Curve – a graph showing the relationship between bond yields and maturities. Normal Yield Curve – an upward-slopping yield curve. Inverted (Abnormal) Yield Curve – a downward-slopping yield curve. Humped Yield Curve – a yield curve where interest rates on intermediate-term maturities are higher than rates on both short- and long-term maturities. B. Interest Rate Risk Interest Rate Risk – is the risk of capital losses to which investors are exposed because of changing interest rates. Maturity Risk Premium (MRP) – a premium that reflects interest rate risk. Reinvestment Rate Risk – the risk that a decline in interest rate will lead to lower income when bonds mature and funds are reinvested. C. Interest Rate Derivatives The Real Risk-Free Rate of Interest, R* o Is the interest rate that would exist on a risk-less security if no inflation were expected. It may be thought of as the rate of interest on short-term U.S. Treasury securities in an inflation-free world. The real risk-free rate is not static—it changes over time, depending on economic conditions, especially on (1) the rate of return that corporations and other borrowers expect to earn on productive assets and (2) people’s time preferences for current versus  future consumption. Borrowers’ expected returns on real assets set an upper limit on how much borrowers can a_ord to pay for funds, whereas savers’ time preferences for consumption establish how much consumption savers will defer—hence, the amount of money they will lend at di_erent interest rates. The Nomimal, or Quoted, Risk-Free Rate of Interest, rRF = r* + IP o The rate of interest on a security that is free of all risk; rRF is proxied by the T-bill rate of the T-bond rate; rRF includes an inflation premium. o To be strictly correct, the risk-free rate should be the interest rate on a totally risk-free security—one that has no default risk, maturity risk, no liquidity risk, no risk of loss if inflation increases, and no risk of any other type. o If the term risk-free rate is used without the modifiers real or nominal, people generally mean the quoted (or nominal) rate; and we follow that convention in this book. Therefore, when we use the term risk-free rate, rRF, we mean the nominal risk-free rate, which includes an inflation premium equal to the average expected inflation rate over the remaining life of the security. Inflation Premium (IP) o A premium equal to expected inflation that investors add to the real risk free rate of return. Default Risk Premium (DRP) o The risk that a borrower will default, which means the borrower will not make scheduled interest or principal payments, also a_ects the market interest rate on a bond: The greater the bond’s risk of default, the higher the market rate. Liquidity Premium (LP) o A “liquid” asset can be converted to cash quickly at a "fair market value." Real assets are generally less liquid than financial assets, but di_erent financial assets vary in their liquidity. Because they prefer assets that are more liquid, investors include a liquidity premium (LP) in the rates charged on di_erent debt securities. D. Monetary Policy Monetary policy is a set of tools used by a nation’s central bank to control the overall money supply and promote economic growth and employ strategies such as revising interest rates and changing bank reserve requirements. Types of Monetary Policy Contractionary – is policy that increases interest rates and limits the outstanding money supply to slow growth and decrease inflation, where the prices of goods and services in an economy rise and reduce the purchasing power of money. Expansionary – during times of slowdown or a recession, an expansionary policy grows economic activity. By lowering interest rates, saving becomes less attractive, and consumer spending and borrowing increase. Goals of Monetary Policy Inflation - Contractionary monetary policy is used to temper inflation and reduce the level of money circulating in the economy. Expansionary monetary policy fosters inflationary pressure and increases the amount of money in circulation. Unemployment - An expansionary monetary policy decreases unemployment as a higher money supply and attractive interest rates stimulate business activities and expansion of the job market. Exchange Rates - The exchange rates between domestic and foreign currencies can be a_ected by monetary policy. With an increase in the money supply, the domestic currency becomes cheaper than its foreign exchange. Tools of Monetary Policy - Open Market Operations: In open market operations (OMO), the Federal Reserve Bank buys bonds from investors or sells additional bonds to investors to change the number of outstanding government securities and money available to the economy as a whole. The objective of OMOs is to adjust the level of reserve balances to manipulate the short-term interest rates and that a_ect other interest rates. - Interest Rates: The central bank may change the interest rates or the required collateral that it demands. In the U.S., this rate is known as the discount rate. Banks will loan more or less freely depending on this interest rate. - Reserve Requirements: Authorities can manipulate the reserve requirements, the funds that banks must retain as a proportion of the deposits made by their customers to ensure that they can meet their liabilities. Lowering this reserve requirement releases more capital for the banks to o_er loans or buy other assets. Increasing the requirement curtails bank lending and slows growth. E. Yield Curve A graph showing the relationship between bond yields and maturities. The yield curve changes in position and in slope over time. o “Normal” Yield Curve – an upward-sloping yield curve. o Inverted (“Abnormal”) Yield Curve – a downward-sloping yield curve. o Humped Yield Curve – a yield curve where interest rates on intermediate-term maturities are higher than rates on both short- and long-term maturities. What Determines the Shape of the Yield Curve? Because maturity risk premiums are positive, if other things were held constant, long-term bonds would always have higher interest rates than short-term bonds. F. Inflation and Interest Rates Interest rates tend to move in the same direction as inflation but with lags, because interest rates are the primary tool used by central banks to manage inflation.  In the U.S. the Federal Reserve targets an average inflation rate of 2% over time by setting a range of its benchmark federal funds rate, the interbank rate on overnight deposits. Higher interest rates are generally a policy response to rising inflation. Conversely, when inflation is falling and economic growth slowing, central banks may lower interest rates to stimulate the economy. How Changes in Interest Rates A_ect Inflation? In general, rising interest rates curb inflation while declining interest rates tend to speed inflation. When interest rates decline, consumers spend more as the cost of goods and services is cheaper because financing is cheaper. Increased consumer spending means an increase in demand and increases in demand increases prices. Conversely, when interest rates rise, consumer spending and demand decline, money-flows reverse, and inflation is somewhat tempered. How Do Interest Rates A_ect Stocks? In general, rising interest rates hurt the performance of stocks. If interest rates rise, that means individuals will see a higher return on their savings. This removes the need for individuals to take on added risk by investing in stocks, resulting in less demand for stocks. The Bottom Line Interest rates influence stocks, bond interest rates, consumer and business spending, inflation, and recessions. However, there is often a lag in the timing between an interest rate change and its e_ect on the economy. Some sectors may react quickly, such as the stock market, while the e_ect on other sectors such as mortgages and auto loans can take longer to be felt. By adjusting the federal funds rate, the Fed helps keep the economy in balance over the long term. Understanding the relationship between interest rates and the U.S. economy will allow investors to understand the big picture and make better investment decisions. Although the relationship between interest rates and the stock market is fairly indirect, the two tend to move in opposite directions. As a general rule of thumb, when the Federal Reserve cuts interest rates, it causes the stock market to go up; when the Federal Reserve raises interest rates, it causes the stock market to go down. But there is no guarantee as to how the market will react to any given interest rate change. A. Corporate Taxation before the losses can be deducted. are collected by the government profit earned by a corporation may be left within as a source of income. It is based on taxable income the corporation, allowing for tax planning and after expenses have been deducted. potential future tax advantages. Corporations are permitted to reduce taxable The corporate tax rate is a tax levied on a corporation's income by certain necessary and ordinary business profits, collected by a government as a source of expenditures. All current expenses required for income. It applies to a company's income, which is the operation of the business are fully tax- revenue minus expenses. deductible. Investments and real estate purchased % States with the intent of generating income for the may also impose a separate corporate tax on business are also deductible. companies. Companies often seek to lower their Corporations are permitted to reduce taxable corporate tax obligations through taking advantage of income by certain necessary and ordinary business deductions, loopholes, subsidies, and other practices. expenditures. All current expenses required for the operation of the business are fully tax- B. Individual Taxation deductible. Investments and real estate purchased with the intent of generating income for the business are also deductible. Also referred to as personal income tax. This type of income tax is levied on an individual’s wages, salaries, and other types of income. A central issue relating to corporate taxation is the This tax is usually a tax that the state imposes. concept of double taxation. Certain corporations are Because of exemptions, deductions, and credits, taxed on the taxable income of the company. If this net most individuals do not pay taxes on all of their income is distributed to shareholders, these individuals income.While a deduction can lower your taxable are forced to pay individual income taxes on the income and the tax rate used to calculate your tax, dividends received. Instead, a business may register as a tax credit reduces your income tax obligation. an S corporation and have all income pass-through to Tax credits help reduce the taxpayer’s tax the business owners. As S corporation does not pay obligation or amount owed. They were created corporate tax, as all taxes are paid through individual primarily for middle- income and lower-income tax returns. households. Paying corporate taxes can be more beneficial for The percent of your income that is taxed depends on business owners than paying additional individual how much you earn and your filing status. In theory, the income tax. more you earn, the more you pay. Corporate tax returns deduct medical insurance for families as well as fringe benefits, including retirement plans and tax-deferred trusts. It is To calculate income tax, you’ll need to add up all sources easier for a corporation to deduct losses, too. of taxable income earned in a tax year. The next step A corporation may deduct the entire amount of is calculating your adjusted gross income (AGI). Once you losses, while a sole proprietor must provide have done this, subtract any deductions for which you evidence regarding the intent to earn a profit are eligible from your AGI. All taxpayers pay federal income tax. Depending on There are many ways to reduce taxes that are not where you live, you may have to pay state and local only available to high-income earners but to all earners. income taxes, too. The U.S. has a progressive income These include contributing to retirement accounts, tax system, which means that higher-income earners contributing to health savings accounts (HSAs), investing pay a higher tax rate than those with lower incomes. in stocks with qualified dividends, buying municipal bonds, Most taxpayers do not pay taxes on all of their and planning where you live based on favorable tax income, thanks to exemptions and deductions. treatments of a specific state. C. Tax Planning and Optimization is the analysis of a financial Tax planning involves utilizing strategies that lower the situation or plan to ensure that all elements work taxes that you need to pay. There are many legal ways together to allow you to pay the lowest taxes in which to do this, such as utilizing retirement plans, possible. holding on to investments for more than a year, and A plan that minimizes how much you pay in taxes offsetting capital gains with capital losses. is referred to as tax efficient. Tax planning should be an essential part of an individual investor's financial plan. Reduction of tax liability and FINANCIAL ANALYSIS AND maximizing the ability to contribute to retirement REPORTING plans are crucial for success. Tax planning covers several considerations. A. Financial Statements Analysis Considerations include timing of income, size, and timing of purchases, and planning for other It is the process of analyzing a company’s expenditures. Also, the selection of investments financial statements for decision-making and types of retirement plans must complement purposes. External stakeholders use it to the tax filing status and deductions to create the understand the overall health of an organization best possible outcome. and to evaluate financial performance and business value. Internal constituents use it as a monitoring tool for managing finances. is another form of tax planning or management relating to investments. It is helpful because it can use a portfolio's losses to The financial statements of a company record offset overall capital gains. According to the IRS, important financial data on every aspect of a short and long-term capital losses must first be business’s activities. As such, they can be used to offset capital gains of the same type. evaluated on the basis of past, current, and In other words, long-term losses offset long-term projected performance. gains before offsetting short-term gains. Short- are centered around term capital gains, or earnings from assets owned generally accepted accounting principles (GAAP) for less than one year, are taxed at ordinary in the United States. These principles require a income rates. company to create and maintain : the balance sheet, the income statement, and the cash flow statement. Some of the most basic tax planning strategies include Public companies have stricter standards for reducing your overall income, such as by contributing to financial statement reporting. Public companies retirement plans, making tax deductions, and taking must follow GAAP, which requires accrual advantage of tax credits. accounting.  Private companies have greater flexibility in their company’s expense arrangements and the debt financial statement preparation and have the capital it is paying off; and shareholder equity option to use either accrual or cash accounting. includes details on equity capital investments and Several techniques are commonly used as part retained earnings from periodic net income. of financial statement analysis The balance sheet must balance assets and are horizontal liabilities to equal shareholder equity. This figure is analysis, vertical analysis, and ratio analysis. considered a company’s book value and serves compares data as an important performance metric that horizontally, by analyzing values of line increases or decreases with the financial items across two or more years. It activities of a company. involves comparing historical data. Usually, the purpose of horizontal analysis is to detect growth trends across different time periods. breaks down the revenue that a company earns looks at the vertical against the expenses involved in its business to effects that line items have on other provide a bottom line, meaning the net profit or parts of the business and the loss. business’s proportions. It compares The income statement is broken into three parts items on a financial statement in that help to analyze business efficiency at three relation to each other. For instance, an different points. It begins with revenue and the expense item could be expressed as a direct costs associated with revenue to identify percentage of company sales. gross profit. It then moves to operating profit, uses important ratio which subtracts indirect expenses like marketing costs, general costs, and depreciation. Finally, metrics to calculate statistical after deducting interest and taxes, the net relationships. It is a central part of income is reached. fundamental equity analysis, compares line-item data. Price-to-earnings (P/E) Basic analysis of the income statement usually ratios, earnings per share, or dividend involves the calculation of gross profit margin, yield are examples of ratio analysis. operating profit margin, and net profit margin, which each divide profit by revenue. Profit margin helps to show where company costs are low or high at different points of the operations. Companies use the balance sheet, income statement, and cash flow statement to manage the operations of their business and to provide transparency to their stakeholders. All three statements are The cash flow statement provides an overview interconnected and create different views of a of the company’s cash flows from operating company’s activities and performance. activities, investing activities, and financing activities. Net income is carried over to the cash flow statement, where it is included as the top line a report of a company’s financial worth in terms item for operating activities. Like its title, of book value. It is broken into three parts to investing activities include cash flows involved include a company’s assets, liabilities, and with firm-wide investments. The financing shareholder equity. activities section includes cash flow from both Short-term assets such as cash and accounts debt and equity financing. The bottom line shows receivable can tell a lot about a company’s how much cash a company has available. operational efficiency; liabilities include the  to convert its inventory into sales. - Companies and analysts also use free debt to assets - It is a leverage ratio that defines cash flow statements and other valuation statements how much debt a company carries compared to to analyze the value of a company. Free cash flow the value of the assets it owns. statements arrive at a net present value by debt to equity - Lenders have priority over equity discounting the free cash flow that a company is investors in an enterprise’s assets. The more estimated to generate over time. Private companies equity there is, the more likely a lender will be may keep a valuation statement as they progress repaid. toward potentially going public. gross profit margin – How much profit is earned Financial statements are maintained by from your products without considering indirect companies daily and used internally for business costs. Small changes in gross margin can management. In general, both internal and significantly affect profitability. external stakeholders use the same corporate operating profit margin - measures how much finance methodologies for maintaining business profit a company makes on a dollar of sales after activities and evaluating overall financial paying for variable costs of production, such as performance. wages and raw materials, but before paying When doing comprehensive financial statement interest or tax analysis, analysts typically use multiple years of net profit margin- This ratio measures your data to facilitate horizontal analysis. Each financial ability to cover all operating costs including statement is also analyzed with vertical analysis indirect costs to understand how different categories of the tax ratio efficiency – show how much income statement are influencing results. Finally, ratio an individual retains. The higher the proportion, analysis can be used to isolate some the more tax efficient a taxpayer is. performance metrics in each statement and interest coverage - measures how well a firm bring together data points across statements can pay the interest due on outstanding debt. collectively. Below is a breakdown of some of the most common cash and earnings before interest taxes, ratio metrics: depreciation, and amortization (EBITDA) - an alternate measure of profitability to net income. asset turnover – How efficiently your business EBITDA attempts to represent the cash profit generates sales on each dollar of assets. An generated by the company's operations. increasing ratio indicates you are using your These metrics may be shown on a per-share basis. assets more productively. quick ratio – This is often referred to as the return on assets (ROA) - Measures your ability “acid test” because it only looks at the company’s to turn assets into profit. This is a very useful most liquid assets only (excludes inventory) that measure of comparison within an industry. A low can be quickly converted to cash). ratio compared to industry may mean that your receivables turnover – The higher the turnover, competitors have found a way to operate more the shorter the time between sales and efficiently. collecting cash. return on equity (ROE) - Rate of return on days to sales - measurement of the average investment by shareholders. This is one of the number of days or time required for a business most important ratios to investors.  DuPont analysis - an alternate way to calculate and deconstruct ROE (Return on Equity) in order to get a better understanding of the underlying factors behind a company’s ROE. The simplest Dupont formula, the three-step method, is done by simply multiplying the three determinants of three main components–net profit margin, total asset turnover, and equity multiplier–to determine the ROE. The main point of financial statement analysis is to evaluate a company’s performance or value through a company’s balance sheet, income statement, or statement of cash flows. By using a number of techniques, such as horizontal, vertical, or ratio analysis, investors may develop a more nuanced picture of a company’s financial profile. An analyst may first look at a number of ratios on a company’s income statement to determine how efficiently it generates profits and shareholder value. For instance, gross profit margin will show the difference between revenues and the cost of goods sold. If the At the same time, the analyst may observe that the gross profit margin has been increasing over nine fiscal periods, applying a horizontal analysis to the company’s operating trends.