Hoss Cents Free Financial Money Magazine

Sunday, August 2, 2009

Calculating Return On Equity (ROE)

From The Hoss's Mouth

Financial analysts differ in their opinions of the value of using Return On Equity calculations to evaluate whether or not to buy shares in a company. Before Money Magazine Hoss gives you the pros on cons of this argument, lets examine the equation for calculating Return On Equity (ROE).

ROE= Net Income/Shareholder Equity

Financial analysts in favour of using ROE as an indication of when to buy stock suggest that you track ROE, and when you see a company with a double digit ROE and which is continually increasing it might be wise to consider buying the stock. You can use one of the many free or pay for service financial web sites available on the Internet for tracking ROE. Note: Not all continue to list ROE, but many do.

Other financial analysts consider ROE to be of little or no value to the potential investor. They point out that Net Income is not always a reliable corporate performance measurement. Why? Because companies use varying accounting procedures when calculating items such as capitalization, depreciation and growth rate, to name a few. Therefore, they conclude the formula for calculating ROE is not always reliable to determine a company’s success or corporate value.

The differing opinions are not unlike those of handicappers selecting a horse to bet on. Some use a horse’s total earnings divided by total races to determine the horse’s potential class. Many handicappers frown on this practice, as it does not take into account other factors such as but not limited to age, sex, distance, and surface.

In summary, the use of ROE by investors as a tool for investment purposes is a matter of personal choice.

Stay on Track,

Money Magazine Hoss

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Calculating Net Profit Margin

Saturday, July 25, 2009

Calculating Net Profit Margin

From The Hoss's Mouth

Money Magazine Hoss continues his series on financial performance ratio calculations with today's post highlighting Net Profit Margin. This ratio tells the potential investor how much profit a company generates for every $1 of revenue. It is considered to be a measurement of a company's efficiency in converting revenue to profit. Investors normally prefer companies with a high net profit margin. Formula as follows:

Net Profit Margin = Net income/Revenue * 100 %

We will continue using the income statements of Amazon, GM and Google to provide examples.

Amazon's Net Profit Margin :

2006: $190,000/$10,711,000 * 100 = 1.8%

2007: $476,000/$14,835,000 * 100 = 3.2%

2008: $645,000/$19,166,000 * 100 = 3.4%

GM's Net Profit Margin:

2006: -$1,978,000/$207,349,000 * 100 = -9.5%

2007: -$43,297,000/$181,122,000 * 100 = -24%

2008: -$30,860000/$148,979,000 * 100 = -20.7%

Google's Net Profit Margin:

2006: $3,077,446/$10,604,917 * 100 = 29%

2007: $4,203,720/$16,593,986 * 100 = 25.3%

2008: $4,226,858/$13,174,044 * 100 = 32.1%

Once again, as in Money Magazine Hoss's previous financial indicator examples, when we compare the Net Profit Margin of the three companies, Google without question has the best performance.

Stay on Track,

Money Magazine Hoss

Next Hoss Cents Free Financial Money Magazine Post: Calculating Return On Equity
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Related Posts:

Financial Statements Explained

The Balance Sheet

The Income Statement

Calculating Gross profit Margin Calculating Operating Margin

Investment Strategy Dollar Cost Averaging

Market Timing

Saturday, July 18, 2009

Interest Coverage Ratio

From The Hoss's Mouth

Interest coverage ratio is the topic of today's Hoss Cents Free Financial Money Magazine. This ratio indicates a company's capacity to make its interest payments (on all outstanding debts) with its earnings before interest and taxes. Think of it this way, how often could you make the interest payments all your outstanding debts with your annual pre-tax income? This is of great importance to bond and preferred stock investors. It gives these investors an indication of the company's financial stability and how far earnings can fall before possible bond or preferred stock payment defaults.

The higher the ratio the less a company is burdened by debt expense. A company's ability to meet interest expenses becomes suspect when the interest coverage ratio is 1.5 or lower. An interest coverage ratio below 1 is a strong red flag, as the company does not have sufficient revenues to pay its interest expenses. Exception: Some companies may have no debt and therefore no interest payments, in which case their Interest coverage ratio would be 0, which of course is excellent.

Interest coverage ratio is calculated as follows:

EBIT (earnings before income and taxes) divided by Interest Expense.

Money Magazine Hoss will again, as in Calculating Gross Profit Margin Percentage and Calculating Operating Margin, use the Income Statements of Amazon, Google and GM for demonstrating how to calculate interest coverage ratio.

Interest Coverage Ratio for Amazon:

2006: $455,000/$78,000 = 5.8

2007: $737,000/$77,000 = 9.4

2008: $972,000/$71,000 = 13.7

In all three years Amazon's Interest Coverage Ratio is well above the warning level of 1.5. In addition the ratio has increased each year which is a positive signal.

Interest Coverage Ratio for GM:

2006: $11,998,000/$16,945,000 = .71

2007: $-3,351,000/$2,902,000 = -1.15

2008: $-27,043,000/$2,345,000 = -11.53

If you considered buying GM stock in 2006, the interest coverage ratio of .71 would have been a warning sign that things were not at all well with this company. The continued deterioration in 2007 and 2008 confirmed this warning sign: Definitely a poor investment. In fact as we all now know, GM subsequently filed for Chapter 11 bankruptcy protection.

Interest Coverage Ratio for Google:

2006: $4,011,297/$257 = 15,608.16

2007: $5,675,183/$1,203 = 4,717.52

2008: $5,853,596/$0 = 0

Google once again is the star. Its ratios are off the chart, and in fact as can be seen in the year 2008, they had no interest expense.

Stay on Track,

Money Magazine Hoss

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