PRINCIPLES OF INVESTMENT

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PRINCIPLES OF INVESTMENT

• DR. KHALED FOUAD SHERIF
• SECTOR MANAGER
• EASTERN EUROPE CENTRAL
• ASIA DEPARTMENT
• THE WORLD BANK
• WASHINGTON D.C.
• Internet
  http\\www.ksherif.com

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PRINCIPLES OF INVESTMENT

• To understand investing you must understand
  financial statements (I.e. balance sheets/income
  statements)
• The balance sheet summarizes the financial
  position of an organization at a given moment, it
  is a snapshot of the firm. The balance sheet
  reflects the status of the organizations assets,
  (the economic resources owned by the
  organization), liabilities (debts owned to
  creditors), and equity (the owners investment in
  the organization).

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PRINCIPLES OF INVESTMENT

• As its name implies the balance sheet should
  indicate that these elements are in balance.
• Assets Liabilities Equity
• This fundamental relationship must always
  exist, because the assets represent the things
  owned by the organization and the liabilities and
  equity indicate how much was supplied by both
  creditors and owners.

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PRINCIPLES OF INVESTMENT

• In contrast to the balance sheet, the income
  statement shows the organization's financial
  progress over a given period of time. The income
  statement is also based on equation
• Revenues - Expenses Profit (or Loss)

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PRINCIPLES OF INVESTMENT

• Revenues are the resources, primarily cash,
  coming into the organization as a result of goods
  sold or services rendered. Expenses are the
  resources used by the organization to provide
  goods or services. If revenues are greater than
  expenses, the business has realized a profit. If
  expenses exceed revenue the business has realized
  a loss from operations. As you read the
  following detailed descriptions of balance sheets
  and income statements, keep in mind that there is
  a direct and important relationship between the
  two. The profit (or loss) realized by a business
  over a period of time affects the amount of
  equity. Equity in a business comes from two
  sources Direct investment by the owners and
  profits from business operations. Therefore, the
  bridge between the income statement and the
  balance sheet is in the relationship between
  equity and profit or loss.

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PRINCIPLES OF INVESTMENT

• Income Statements
• Exhibit 1 shows a sample income statement (see
  next page) for a period covering January 1 to
  December 31, 1989. The company in question
  earned revenues from two sources
• Net sales All sources earned by the company
  from the sale of its products and services.
• Other income Generally resources from sources
  as interest on bank accounts, cash dividends from
  investments in other companies, and interest on
  bonds.

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PRINCIPLES OF INVESTMENT

• The following expenses are subtracted from
  revenues
• Cost of goods sold all the expenses incurred in
  making the products sold during the period,
  including the cost of materials, labor, and
  factory overhead (rent, utilities and
  maintenance).

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EXHIBIT 1SAMPLE INCOME STATEMENT
Company X For year ending December 31, 1989 (In
LE) Revenues Net Sales 3,787,248 Other
Income 42,579 Total Revenues 3,829,827 Expenses
Cost of Goods Sold 2,796,459 Administrative
Selling Expenses 637,509 Interest
Expenses 47,516 Total Expenses 3,503,545 Earnings
Before Income Taxes 326,282 Income
Taxes 152,039 Net Earnings 174,243
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PRINCIPLES OF INVESTMENT

• Administrative and selling expenses The costs
  of running and promoting the business, including
  items like the presidents salary, the salaries
  of all management personnel, advertising costs
  and sales commissions.
• Interest expenses The interest that the company
  paid during the year on money that it borrowed.

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PRINCIPLES OF INVESTMENT

• Other Expenses This would include any other
  unusual expenses incurred by the company to run
  the business not otherwise accounted for above
  (e.g. research and development expenses, and
  organizational costs).

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PRINCIPLES OF INVESTMENT

• Expenses are subtracted from revenues to yield
  a figure that indicates the companys earnings,
  but this figure still does not reflect the
  companys profit. During 1989 the company paid
  over 46 percent of its earnings to the tax
  department in the form of taxes. Thus, its net
  earnings, or the amount of profit the company
  earned in 1989, is LE 174, 243.

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PRINCIPLES OF INVESTMENT

• Balance sheets
• Exhibit 2 is the balance sheet for Company X
  as of December 31, 1989. The first component is
  assets, current and fixed. Current assets, are
  those the business expects to turn into cash
  during the next year. The cash generated from
  current assets is used to pay expenses and repay
  liabilities. Current assets include

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PRINCIPLES OF INVESTMENT

• Cash.
• Marketable securities Temporary investments
  (generally 90 days) of excess or idle cash
  listed at cost, or market value since they are
  converted into cash within one year.
• Accounts Receivable Money owned to the company
  by debtors, generally for the purchase of goods
  and services.
• Inventories The value of products that have
  been completed and are in storage waiting to be
  sold (finished goods), products that have been
  partially completed (work in process), and raw
  materials.
• Prepaid Expenses The value of items that the
  company has paid for in advance, such as
  insurance premiums.

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PRINCIPLES OF INVESTMENT

• Fixed assets are things of value that will
  provide benefits to the company for one or more
  years. Fixed assets are reported in three
  categories land, buildings, machinery and
  equipment. Fixed assets are reported on the
  balance sheet at the cost to purchase or acquire
  the asset minus the depreciation accumulated on
  the assets since the time of purchase.
  Depreciation is the estimated decline in the
  useful value of an asset due to gradual wear and
  tear. Since this decline in value cannot be
  estimated with certainly, accountants use various
  standards methods to approximate it.

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SAMPLE BALANCE SHEET
Company X December 31, 1989 Assets Liabilities
Current Assets Current Liabilities Cash 59,770
Notes Payable 48,563 Marketable
securities 87,466 Trade accounts
payable 207,887 Accounts receivable 559,144 Payrol
ls other accurables 411,362 Inventory 618,120 In
come taxes 124,684 Prepaid Expenses 49,986 Total
Current Liabilities 792,496 Total Current
Assets 1,374,486 Long-Term Liabilities 431,350 Fix
ed Assets Total Liabilties 1,223,846 Land 25,807
Buildings 716,076 Shareholders
Equity 1,103,190 Machinery Equipment 1,010,770
Less allowances for depreciation 800,103 Total
Fixed Assets 952,550 Total Assets 2,327,036
Total Liabilties Equity 2,327,036
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PRINCIPLES OF INVESTMENT

• The second major section in a balance sheet is
  devoted to liabilities. Current liabilities are
  the debts that a company must pay off within the
  coming year
• Notes payable Money owned to banks or other
  lending institutions generally short-term loans
  (up to one year) used to finance short-term needs.

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PRINCIPLES OF INVESTMENT

• Accounts payable Money owed to vendors for the
  purchase of goods and services.
• Payrolls and other accurables Money owed to
  people for institutions that have performed
  services, including salaries owed to employees,
  salaries owed to employees on vacation, attorney
  fees, insurance premiums, and pension funds.
• Income taxes Money owed to the Tax Department
  may sometimes be deferred and paid later but must
  always be paid.

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PRINCIPLES OF INVESTMENT

• Long-term liabilities are obligations, usually
  loans, that are due to be paid not in the current
  year but in some future period. The amount
  specified in the balance sheet is equal to the
  total amount borrowed.

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PRINCIPLES OF INVESTMENT

• The final major section, the equity section
  summarizes the owners investment in the
  business. Individuals and institutions become
  owners of a company by purchasing shares of the
  companys stock. Equity increases as more people
  purchase stock and the company retains increased
  profit.

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PRINCIPLES OF INVESTMENT

• Each type of analysis of financial data has a
  purpose or use that determines the different
  relationships emphasized. Therefore, it is
  useful to classify ratios into four fundamental
  types
• Liquidity ratios, measure the firms ability to
  meet its maturing short-term obligations.

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PRINCIPLES OF INVESTMENT

• Leverage ratios, measure the extent to which the
  firm has been financed by debt.
• Activity ratios, measure how effectively the firm
  is using its resources.
• Profitability ratios, measure managements overall
  effectiveness as shown by the returns generated
  on sales and investment.

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PRINCIPLES OF INVESTMENT

• Liquidity Ratios
• Generally, the first concern of the financial
  analyst is liquidity. they measures the
  short-run solvency of a company its ability to
  meet current debts.
• Current Ratio
• The current ratio indicates whether there are
  enough current assets to meet current
  liabilities.
• Current ratio Current assets
• Current liabilities

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PRINCIPLES OF INVESTMENT

• Current assets normally include Cash,
  marketable securities, accounts receivable, and
  inventories.
• Current liabilities consist of accounts
  payable, short-term notes, payable, current
  maturities of long-term debt, accrued income
  taxes, and other accrued expenses (principally
  wages).

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PRINCIPLES OF INVESTMENT

• When is the company solvent? When the current
  ratio is 1.0 or greater that is, the company
  should have more current assets than current
  liabilities.
• Method for Calculating the Current Ratio
• Add cash, marketable securities, accounts
  receivable, and inventories to get current assets.

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PRINCIPLES OF INVESTMENT

• Add notes payable, trade accounts payable,
  payrolls and other accurables and income taxes to
  get current liabilities.
• Divide the derived current assets figure by the
  calculated current liabilities figure.

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PRINCIPLES OF INVESTMENT

• You have now derived the current ratio. Now,
  compare the value derived to 1.0. If the
  current ratio is 1.0 or greater, the company
  should have more current assets than current
  liabilities and is financially viable or solvent.
  If the current ratio is less than 1.0, the
  company will have more current liabilities than
  current assets and is financially unviable or
  insolvent.

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PRINCIPLES OF INVESTMENT

• For significance this ratio should be compared to
  previous years (e.g. the current ratio for five
  previous years should be derived). This is
  necessary in order to derive a trend. If the
  current ratio is rising n an upward fashion, the
  company is becoming more financially viable. If
  the current ratio is falling and assuming a
  downward trend, the company is becoming less
  financially viable.

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PRINCIPLES OF INVESTMENT

• One helpful activity is to also compare the
  current ratio of the company in question to the
  current ratio of similar competing companies. If
  the company in question has a higher current
  ratio on a regular basis over a number of years
  than this company is more financially viable. On
  the other hand, if the company in question has a
  lower current ratio on a regular basis over a
  number of years than this company is less
  financially viable.

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PRINCIPLES OF INVESTMENT

• b - Quick Ratio, or Acid Test
• The quick ratio is calculated by deducting
  inventory from current assets, and dividing the
  remainder by current liabilities. Inventories
  are deducted since they are typically the least
  liquid of a firms current assets.
• Quick ratio Current assets - Inventory
• Current Liabilities

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PRINCIPLES OF INVESTMENT

• When is the company solvent? When the Quick
  ratio is 1.0 or greater.
• Which liquidity ratio is more accurate, the
  current ratio or the quick ratio? The quick
  ratio, since it excludes inventory, the least
  liquid asset, and the asset on which losses are
  most likely to occur in the event of liquidation.

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PRINCIPLES OF INVESTMENT

• Method for Calculating the Quick Ratio
• Add cash, marketable securities and accounts
  receivable (items 16, 17, 18 on the sample
  balance sheet on page 6) to get quick assets
  (quick assets by definition is current assets -
  inventory).

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PRINCIPLES OF INVESTMENT

• Add notes payable, trade accounts payable,
  payrolls and other accurables and income taxes
  (items 31, 32, 33 34 on the sample balance
  sheet on page 6) to get current liabilities.
• Divide the derived quick assets figure by the
  calculated current liabilities figure.

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PRINCIPLES OF INVESTMENT

• You have now derived the quick ratio. Now,
  compare the value derived to 1.0. If the quick
  ratio is 1.0 or greater, the company should have
  more quick assets than current liabilities and is
  financially viable or solvent. If the quick
  ratio is less than 1.0, the company will have
  more current liabilities than quick assets and is
  financially unviable or insolvent.

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PRINCIPLES OF INVESTMENT

• For significance this ratio should be compared to
  previous years (e.g. the quick ratio for five
  previous years should be derived). This is
  necessary in order to derive a trend. If the
  quick ratios is rising in an upward fashion, the
  company is becoming more financially viable. If
  the quick ratio is falling and assuming a
  downward trend, the company is becoming less
  financially viable.

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PRINCIPLES OF INVESTMENT

• One helpful activity is to also compare the quick
  ratio of the company in question to the quick
  ratio of similar competing companies. If the
  company in question has a higher quick ratio on a
  regular basis over a number of years then this
  company is more financially viable.

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PRINCIPLES OF INVESTMENT

• Leverage Ratios
• Leverage ratios measure the funds supplied by
  owners as compared with the financing provided by
  the firms creditors.

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PRINCIPLES OF INVESTMENT

• Implications of leverage ratios
• Equity, or owner-supplied funds, provide a margin
  of safety for creditors. Thus, the less equity,
  the more the risks of the enterprise to the
  creditors.

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PRINCIPLES OF INVESTMENT

• Debt funding enables the owners to maintain
  control of the firm with a limited investment.
• If the firm earns more on the borrowed funds than
  it pays in interest, the return to the owners is
  magnified.
• If the firm earns more on the borrowed funds than
  it pays in interest, the return to the owners is
  magnified.

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PRINCIPLES OF INVESTMENT

• Low leverage ratios Indicate less risk of loss
  when the economy is in a downturn, but lower
  expected returns when the economy booms.
• High leverage ratios indicate the risk of large
  losses, but also have a chance of gaining high
  profits.

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PRINCIPLES OF INVESTMENT

• Therefore, decisions about the use of leverage
  must balance higher expected returns against
  increased risk.

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PRINCIPLES OF INVESTMENT

• Approaches to examining leverage ratios
• Debt ratio
• The debt ratio is the ratio of total debt to
  total assets and measures the percentage of total
  funds provided by creditors.
• The debt ratio is Total debts
• Total assets

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PRINCIPLES OF INVESTMENT

• Method for Calculating the Debt Ratio
• Add notes payable to long-term liabilities to get
  total debts.

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PRINCIPLES OF INVESTMENT

• Add cash, marketable securities, accounts
  receivable, inventories, prepaid expenses, land,
  buildings, machinery and equipment and subtract
  depreciation to derive the total assets figure.
• Divide the total debts figure by the calculated
  total assets figure.

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PRINCIPLES OF INVESTMENT

• For significance this ratio should be compared to
  previous year (e.g. the debt ratio for five
  previous years should be derived). This is
  necessary in order to derive a trend. If the
  debt ratio is rising in an upward fashion, the
  company is developing a leverage problem. If the
  debt ratio is falling and assuming a downward
  trend, the company is investing more of its own
  resources to generate assets and is becoming less
  dependent on debts.

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PRINCIPLES OF INVESTMENT

• One helpful activity is to also compare the debt
  ratio of the company in question to the debt
  ratio of similar competing companies. If the
  company in question has a higher debt ratio on a
  regular basis over a number of years, then this
  company is over leveraged in comparison to its
  competitors. On the other hand, if the company
  in question has a lower debt ratio on a regular
  basis over a number of years, then this is less
  dependent on debt as a source of financing in
  comparison to its competitors.

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PRINCIPLES OF INVESTMENT

• B - Debt-to-Equity- Ratio
• This ratio is a variation of the debt ratio that
  is commonly used. It compares the amount of
  money borrowed from creditors to the amount of
  shareholders investment made within a firm.
• Debt-to-Equity ratio Total Debts
• Shareholders investment (equity)

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PRINCIPLES OF INVESTMENT

• Method for Calculating the Debt-to-Equity Ratio
• Add notes payable to long-term liabilities to get
  total debts.

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PRINCIPLES OF INVESTMENT

• Look up the shareholders investment or equity
  line item in the blance sheet.
• Divide the total debts figure by the calculated
  shareholders investment figure.

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PRINCIPLES OF INVESTMENT

• For significance this ratio should be compared to
  previous years (e.g. the debt to equity ratio for
  five previous years should be derived). This is
  necessary in order to derive a trend. If the
  debt to equity ratio is rising in an upward
  fashion, the company is developing a leverage
  problem. If the debt ito equity ratio is falling
  and assuming a doward trend, the company is
  investing more of its owners resources to
  generate assets and is becoming less dependent on
  creditors.

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PRINCIPLES OF INVESTMENT

• One other helpful activity is to also compare the
  debt to equity ratio of the company in question
  to the debt equity ratio of similar competing
  companies. If the company in question has a
  higher debt to equity ratio on a regular basis
  over a number of years, then this company is over
  leveraged in comparison to its competitors. On
  the other hand, if the company in question has
  lower debt to equity ratio on a regular basis
  over a number of years, then this company is less
  dependent on debt as a source of financing in
  comparison to its competitors.

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PRINCIPLES OF INVESTMENT

• Profitability ratios
• Profitability ratios indicate how successful a
  company really is and how effective management is
  in operating the business.

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PRINCIPLES OF INVESTMENT

• A - Return on assets
• This ratio shows how much money the company
  earned on each dollar it invested in assets. It
  is a measure of overall company earning power or
  profitability.
• Return on Assets (ROA) Net Earnings
• Total Assets

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PRINCIPLES OF INVESTMENT

• Method for Calculating the Return on Assets
  Ratio
• Derive the net earnings, or net profit figure
  from the income statement. Net earnings is
  simply total revenues minus total expenses.

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PRINCIPLES OF INVESTMENT

• Add cash, marketable securities, accounts
  receivable, inventories, prepaid expenses, land,
  buildings, machinery and equipment and subtract
  depreciation to derive the total assets figure.
• Divide the net earnings figure by the derived
  total assets figure to get return on assets.

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PRINCIPLES OF INVESTMENT

• For significance this ratio should be compared to
  previous years (e.g. the return on assets ratio
  for five previous years should be derived). This
  is necessary in order to derive a trend. If the
  return on assets ratio is rising in an upward
  fashion, the company is making a larger return on
  funds invested in assets. If the return on
  assets ratio is falling and assuming a downward
  trend, the company is making a lower return on
  funds invested in assets.

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PRINCIPLES OF INVESTMENT

• One other helpful activity is to also compare the
  return on assets ratio of the company in question
  to the return on assets of similar competing
  companies. If the company in question has a
  higher ROA on a regular basis over a number of
  years, then this company is financially better
  off in comparison to its competitors. On the
  other hand, if the company in question has a
  lower ROA on a regular basis over a number of
  years, then this company is financially worse off
  in comparison to its competitors.

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PRINCIPLES OF INVESTMENT

• B - Profit Margin
• The profit margin is a ratio that shows the
  relationship between net earnings and net sales
  and indicates how much profit the company is
  earning on each dollar in sales.
• Profit Margin Net Earnings
• Net Sales

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PRINCIPLES OF INVESTMENT

• Method for calculating the profit margin ratio
• Derive the net earnings, or net profit figure
  from the income statement. Net earnings is
  simply total revenues minus total expenses.

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PRINCIPLES OF INVESTMENT

• Derive the net sales line item from the income
  statement.
• Divided the net earnings figure by the derived
  net sales figure to get the profit margin.

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PRINCIPLES OF INVESTMENT

• For significance this ratio should be compared to
  previous years (e.g. the profit margin ratio for
  five previous years should be derived). This is
  necessary in order to derive a trend. If the
  profit margin ratio is rising in an upward
  fashion, the company is making a larger return on
  sales. If the profit margin is falling and
  assuming a downward trend, the company is making
  a lower return on sales.

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PRINCIPLES OF INVESTMENT

• One other helpful activity is to also compare the
  profit margin of the company in question to the
  profit margin of similar competing companies. If
  the company in question has a higher profit
  margin on a regular basis over a number of years,
  then this company is making a larger return on
  sales in comparison to its competitors. On the
  other hand, if the company in question has a
  lower profit margin on a regular basis over a
  number of years, then this company is making a
  lower return on sales in comparison to its
  competitors.

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PRINCIPLES OF INVESTMENT

• C - Return on equity (or return on net worth)
• This ratio indicates the amount of net earnings
  resulting from investments in equity.
  Shareholders are particularly interested in this
  ratio, because it shows them how much they are
  earning on their investments.
• Return on equity Net Earnings
• Shareholders investment (Equity)

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PRINCIPLES OF INVESTMENT

• Method for calculating the return on equity
  ratio
• Derive the net earnings, or net profit figure
  from the income statement. Net earnings is
  simply total revenues minus total expenses.

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PRINCIPLES OF INVESTMENT

• Lookup the shareholders investment or equity
  line item in the balance sheet.
• Divide the net earnings figure by the derived
  shareholders investment figure to get return on
  equity.

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PRINCIPLES OF INVESTMENT

• For significance this ratio should be compared to
  previous years (e.g. the return on equity ratio
  for five previous years should be derived). This
  is necessary in order to derive a trend. If the
  return on equity ratio is rising in an upward
  fashion, the company is making a larger return on
  funds invested by shareholders. If the return on
  equity is falling and assuming a downward trend,
  the company is making a lower return on funds
  invested by shareholders.

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PRINCIPLES OF INVESTMENT

• One other helpful activity is to also compare the
  return on equity of the company in question to
  the return on equity of similar competing
  companies. If the company in question has a
  higher return on equity on a regular basis over a
  number of years, then this company is making a
  larger return on shareholders investment in
  comparison to its competitors. On the other
  hand, if the company in question has a lower
  return on equity on a regular basis over a number
  of years, then this company is making a lower
  return on shareholders investment in comparison
  to its competitors.

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PRINCIPLES OF INVESTMENT

• Activity ratios
• Activity ratios measures how effectively the firm
  employs its resources. These ratios involve
  comparisons between the level of sales and the
  investment in various asset accounts, like
  inventories and accounts receivable.

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PRINCIPLES OF INVESTMENT

• A - Inventory turnover
• Inventory turnover tells us how many times during
  the year the entire stock of inventory was sold.
• Inventory turnover is calculated as follows
• Inventory turnover Sales
• Inventory

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PRINCIPLES OF INVESTMENT

• Method for calculating the inventory turnover
  ratio
• Derive the net sales line item from the income
  statement.
• Derive the inventory valuation figure from the
  balance sheet.
• Divide the sales figure by the derived inventory
  figure to get the inventory turnover.

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PRINCIPLES OF INVESTMENT

• Problems in arising in calculating and analyzing
  this ratio
• Sales are at market prices. If inventories are
  carried at cost, as they generally are, it is
  more appropriate to use cost of goods sold in
  place of sales in the numerator of the formula.
• Sales occur over the entire year, whereas the
  inventory figure is for one point in time. This
  makes it better to use an average inventory,
  computed by adding beginning and ending
  inventories and dividing by 2.

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PRINCIPLES OF INVESTMENT

• B - Average collection period
• The average collection period indicates how
  quickly the company collects its accounts
  receivable.

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PRINCIPLES OF INVESTMENT

• It is computed in the following way
• Annual sales (derived from the income statement)
  are divided by 365 to get average daily sales.
• Accounts receivable (derived from the balance
  sheet) are divided over daily sales to find the
  number of days sales is tied up in receivables.

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PRINCIPLES OF INVESTMENT

• The average collection period represents the
  average length of time the firm must wait to
  receive cash after making a sale and is
  mathematically defined as follows
• Average collection period Accounts
  receivables
• Sales/365 days

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PRINCIPLES OF INVESTMENT

• Evaluation of this ratio is based upon the terms
  on which the firm sells its goods. For example,
  if the collection period over the past few years
  for a given company is lengthy while its credit
  policy did not change, this would be evidence
  that steps should be taken to expedite the
  collection of accounts receivable.

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SUMMARY OF FINANCIAL RATIOS
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SUMMARY OF FINANCIAL RATIOS (CONTD)
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FINANCIAL RATIOS
II. Ratios indicating asset relations and
capital set-up or relating to analysis of
long-term solvency
A. Equities related to profits and sales
1. Sales to owners equity
Net Sales Owners Equity
Numberof times net worth is turned over in
sales Indicative of the utilization of owners
capital may reflect over-capitalization in
relation to volume of business done.
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HOW TO ANALYZE FINANCIAL POSITIONPOTENTIAL FOR
BUSINESS FAILURE

• Bankruptcy occurs when the company is unable to
  meet maturing financial obligations. We are thus
  particularly interested in predicted cash flow.
  Financial difficulties affect the price-earnings
  ratio, and the effective interest rate.

104
HOW TO ANALYZE FINANCIAL POSITIONPOTENTIAL FOR
BUSINESS FAILURE

• A comprehensive quantitative indicator used to
  predict failure is Altmans Z-score, which
  equals
• Working capital Retained earnings
• X 1.2
  X 1.4
• Total assets Total assets
• Operating income MV of common preferred
• X 3.3
  X 0.6
• Total assets Total liabilities
• Sales
• X 0.999
• Total assets
• N.B. Operating income Net sales - cost of
  goods sold

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THE SCORES AND THE PROBABILITY OF SHORT-TERM
ILLIQUIDITY FOLLOW.

• Score Probability of illiquidity or failure
  
• 1.80 or less Very high
• 1.81- 2.99 Not sure
• 3.0 or greater Unlikely

106
EXAMPLE

• A company presents the following information
• Working capital 280,000
• Total assets 875,000
• Total liabilities 320,000
• Retained earnings 215,000
• Sales 950,000
• Operating income 130,000
• Common stock
• Book Value 220,000
• Market Value 310,000
• Preferred stock
• Book value 115,000
• Market value 170,000

107

• Z-score equals
• 280,000 215,000 130,000
• X 1.2 X 1.4
  X 3.3
• 875,000 875,000 875,000
• 480,000 950,000
• X 0.6 X 0.999
  
• 320,000 875,000
• 0.384 0.344 0.490 0.9 1.0846
  3.2026
• The probability of failure is not likely

108
QUANTITATIVE FACTORS IN PREDICTING CORPORATE
FAILURE

• Low cash flow to total liabilities.
• High debt-to-equity ratio and high debt to total
  assets.
• Low return on investment
• Low profit margin
• Low retained earnings to total assets
• Low working capital to total assets and low
  working capital to sales
• Low fixed assets to noncurrent liabilities
• Inadequate interest-coverage ratio
• Instability in earnings
• Small size company measured in sales and/or total
  assets

109
QUANTITATIVE FACTORS IN PREDICTING CORPORATE
FAILURE

• Sharp decline in price of stock, bond price, and
  earnings
• A significant increase in beta. (Beta is the
  variability in the price of the companys stock
  relative to a market index)
• Market price per share is significantly less than
  book value per share
• A significant rise in the companys
  weighted-average cost of capital
• High fixed cost to total cost structure (high
  operating leverage)
• Failure to maintain capital assets. (e.g. decline
  in the ratio of repairs to fixed assets

110
QUANTITATIVE FACTORS IN PREDICTING FAILURE

• New company
• Declining industry
• Inability to obtain adequate financing, and when
  obtained there are significant loan restrictions
• A lack in management quality

111
CONSOLIDATED BALANCE SHEETS
December 31, 1993 1992 Assets Cash 9,150,210 7,67
9,800 Accounts receivable less allowances 6,952,70
0 6,411,470 Inventories 5,755,040 5,293,910 Other
current assets 897,670 895,760 Total current
assets 22,755,620 20,280,940 Investments 304,710 1
74,640 Property, plant and equipment
Land 336,780 292,480 Buildings 4,940,740 4,27
7,040 Machinery Equipment 8,791,660 7,783,0
80 Total Property, Plant
Equipment 14,069,180 12,352,600 Less accumulated
depreciation 5,475,040 4,656,370 Property plant
Equipment net of depreciation 8,594,140 7,696,230
Intangibles 1,934,650 1,828,510 Other
assets 362,990 468,980 Total Assets 33,952,110 30,
449,300 Liabilities Loans payable to
Banks 588,600 616,040 Accounts payable
Accrued Expenses 6,030,420 5,267,770 Total
current liabilities 6,619,020 5,883,810 Long term
Debt 4,415,510 3,679,650 Shareholders
Equity Paid-in Capital 2,003,200 1,288,610 Retaine
d Earnings 20,914,380 19,597,230 Total
Shareholders Equity 22,917,580 20,885,840 Total
Liabilities and Shareholders Equity 33,952,110 30
,449,300
112
CONSOLIDATED STATEMENTS OF INCOME
December 31, 1993 1992 Sales 47,443,200 45,684
,060 Cost of goods sold 18,371,190 17,995,370 Sell
ing, Admin. General Expense 16,959,630 15,944,04
0 35,330,820 33,939,410 Income before interest
and taxes 12,112,380 11,744,650 Interest 1,136,970
1,243,780 Income before taxes 10,975,410 10,500,8
70 Taxes 3,804,010 3,942,590 Net
income 7,171,400 6,558,280
113
Eastern Carpets - Ratio Findings

• Item 94 95 96
• ROA 12.3 7.3 8.7
• ROE 39.0 26.8 29.5
• CR .994 1.02 .947
• DR 68 72.7 70.3
• D/E 217 260 236
• Z Score 1.65 1.38 1.35

114
Eastern Carpets - Issues

• Working capital is WITHOUT the negative sign
• Inventory is missing
• Accounts receivables is missing
• Why does total current assets appear when
  accounts receivables and inventory do not?
• Where is retained earnings?

115
BOOK CASE ANALYSIS Which U.S.
Company is it?

• 1992 1993
• ROA 21.5 21
• ROE 31.4 31.2
• PM 14.3 15
• CR 3.4 3.4
• QR 2.5 2.6
• DR 12 13

• 1992 1993
• D/E 18 19
• IT 5.2 5.9
• Z Score 6.25 5.94

116

PRINCIPLES OF INVESTMENT

• How Markets Function
• Going from a public to private company
• Workings of the financial market and the economy
• Making sense of interest rates, inflation and the
  Central Bank
• The Stock Market and Valuations
• Understanding the Market
• Buying low and selling high
• The Different Ways to Buy Stocks
• Buying stocks
• Sidestepping common stock shopping mistakes
• Understanding the key to stock-investing success

117

PRINCIPLES OF INVESTMENT

• Public versus Private Companies
• Two types of companies public and private
• Reasons to shift from a private business to a
  publicly owned company
• Companys intention to grow or expand
• The need to raise funds (capital)

118

PRINCIPLES OF INVESTMENT

• Why companies issue stocks versus bonds?
• Companies choose between two money-raising
  options when they go into financial markets
• Bonds are loans that a company must pay back
• Advantages businesses do not hand over ownership
  
• Disadvantages interest is usually charged
• Stocks are shares of ownership in a
  companystock issue is not paid back, its not a
  loan
• Advantages no interest is charged
• Disadvantages (a) burdensome financial reporting
  requirements that can also weaken companys
  competitive advantage (b) short-term vs.
  long-term focus on performance

119

PRINCIPLES OF INVESTMENT

• Deciding what to issue
• Stock If stock market is booming and new stock
  can sell at a premium price, companies opt to
  sell more stock.
• Bonds If investors dont believe the company has
  good growth prospects and interest rates are low,
  the company may lean toward bonds.
• Ultimately ? companies seek to raise capital the
  lowest way they can!

120

PRINCIPLES OF INVESTMENT

• What is an IPO?
• Initial Public Offering stock issued for the
  first time
• E.g., a company plans to issue 50 million in
  capital
• Price per Stock No. of Shares Issued
• 5.00 10 million
• 10.00 5 million
• 20.00 2.5 million
• Price per stock, as the only instrument, is not
  used to evaluate whether to buy a stock.
• Price per share depends on companys profits and
  future growth prospects
• Companies that produce higher profits and grow
  faster generally command a higher price.

121

PRINCIPLES OF INVESTMENT

• Profits drive stock prices
• The primary goal of a company is to maximize
  profits.
• Profits result from the difference between what a
  company takes in, revenue, and what it expends,
  costs.
• Higher profits ? stock prices rise
• The key to successful maximization of profits is
  to
• Produce products and services for which demand
  exceeds supply.

122

PRINCIPLES OF INVESTMENT

• Tactics used to increase profits
• Following are the ways successful companies
  increase profits
• Innovate to better meet customer needs
• Open new markets to your products
• Be in related businesses
• Build a brand name
• Manage costs
• Watch the competition

123

PRINCIPLES OF INVESTMENT

• Efficient Market Hypothesis
• How does one predict what happens to stock or
  bond markets?
• The efficient market theory maintains the
  following logic
• Lots of investors collect and analyze all sorts
  of information about companies and their stocks.
  If investors think that a stock is overpriced,
  they sell it or dont buy it. Conversely, if
  investors believe that a stock is under-priced,
  they buy it or hold what they already own.
  Because of competition between investors, the
  price that a security trades at generally
  reflects what many informed and smart people
  think it is worth. No one can outperform the
  market, because the information is equally
  available to all investors.
• No one can outperform the market, because the
  information is equally available to all investors.

124
PRINCIPLES OF INVESTMENT

• Impact of interest rates, inflation and the
  Central Bank on market performance
• High interest rates are generally bad
• Increases in interest rates slow the economy
• Businesses cut back on expansion because the cost
  to borrow is too high
• Consumer spending decreases
• The economy possibly ends up in a recession
• Risk to invest in stocks increases
• Inflation and interest rates usually move
  together
• Purchasing power decreases

125
PRINCIPLES OF INVESTMENT

• Impact of interest rates, inflation and the
  Central Bank on market performance
• The Central bank has a major role in influencing
  market performance by
• Influencing the amount of money in circulation
  money supply.
• Raising or lowering the interest rate charged to
  banks to borrow money in an attempt to influence
  the supply and demand for money.
• Buying and selling government bonds.

126
PRINCIPLES OF INVESTMENT

• The Stock Market and Valuations
• Investing is not a zero-sum game like a casino,
  where for every winner there is a looser
• No insider information is required to profit from
  stock investments
• Higher company profits move the price up
• Nearly all long-term investors can win in the
  stock market because it appreciates over the
  years

127
PRINCIPLES OF INVESTMENT

• What is The Market?
• By market we usually understand the place where
  buyers and sellers gather together to agree on
  price
• By The Market we infer U.S. stock market
• Specifically, The Market means the Dow Jones
  Industrial Average (DJIA)
• DJIA was created in 1889 by compiling stock
  prices of larger, important companies and
  calculated indexes to track the performance of
  the U.S. stock market.

128
PRINCIPLES OF INVESTMENT

• Major stock market indexes
• Dow Jones Industrial Average (DJIA) market index
  tracks the performance of 30 large companies that
  are headquartered in the U.S.
• Standard Poor 500 (SP500) tracks the
  performance of 500 larger-company U.S. stocks.
  SP500 is a larger and more representative index
  of the larger company stocks in the U.S.
• Others NASDAQ (technology), Russell 2000
  (smaller company stocks)
• Many industries have their own indexes
  (utilities, banks, etc.)
• Many countries, such as Japan, the United
  Kingdom, Germany, etc., have indexes that reflect
  markets performance in that particular country.

129
PRINCIPLES OF INVESTMENT

• Reasons to use indexes
• Gives an opinion on peoples expectation of
  future financial performance of publicly traded
  companies
• Compares a particular companys stock performance
  with the entire market
• Explains the movement in a stock price compared
  to indexes
• Industry indexes would show the direction in
  which a particular stock from that industry
  moves
• Industry indexes are more narrow than DJIA or SP
  500

130
PRINCIPLES OF INVESTMENT

• Buy LOW and Sell HIGH
• The basic concept of investment is to buy when
  the price is low and sell when the price is high
• How low should the price fall to buy a stock?
• How high should the price go to sell a stock?
• This basic concept is hard to implement in
  practice
• Statistics show that smaller investors tend to
  sell heavily after major declines and start
  buying after major price increases

131
PRINCIPLES OF INVESTMENT

• How do I buy LOW and sell HIGH
• The simplest and best way to get a return in the
  stock market is to consistently and regularly
  feed new money into building a larger portfolio
• In these cases, when the market goes down, its
  time to buy more shares
• The danger of timing the market is that you may
  be out of the market when the it goes up and
  in the market when it declines

132
PRINCIPLES OF INVESTMENT

• Price-earning ratios
• On its own, the price per share of stock is
  meaningless
• The price-earnings ratio (P/E) compares the level
  of stock prices to the level of corporate
  profits
• P/E ratio shows the willingness of an investor to
  pay the price for a particular stock
• P/E ratios can be calculated for a particular
  stock as well as for the entire market

133
PRINCIPLES OF INVESTMENT

• Calculating price-earning ratios
• Stock Price Per Share
• Price-earning ratio
• Annual Earnings Per Share
• Stock Price Per Share is the actual price a stock
  is sold for
• Annual Earnings Per Share are calculated by
  dividing Annual Earnings (or profits) by number
  of shares company has issued
• Faster-growing companies tend to sell at higher
  P/Es

Company Recent P/E Earnings growth Past 5 years
Sears 17 3
Gillette 43 16
Microsoft 73 35
134
PRINCIPLES OF INVESTMENT

• Ways to Buy Stocks
• Mutual funds are investment companies that
  invest money from individuals into securities,
  such as stocks and bonds.
• Advantages
• Diversification (funds often buy shares in
  hundreds of companies)
• Professional management (full time money mangers
  saves time for the individual)
• Disadvantages
• Less control
• Tax concerns (fund manager decides when to sell,
  sometimes with high levels of taxable
  distribution)

135
PRINCIPLES OF INVESTMENT
Individual Stocks Many like buying individual
stocks, but the vast majority are better off NOT
picking their own stocks! Pros and Cons of
Picking Your Own Stocks
Good reasons Bad reasons
You enjoy the challenge. You think you can beat the best money managers.
You want to learn more about business. You want more control over your investments, which you think may happen if you understand the companies you invest in.
You possess a substantial amount of money to invest. Your think mutual funds arent for people who are smart enough to chose their own.
You are a buy-and-hold investor. You are attracted to the ability to trade your stocks at anytime.
136
PRINCIPLES OF INVESTMENT

• Buying stocks direct from companies
• An increasing number of companies sell stock
  directly to the public.
• Proponents say that you can invest without paying
  commissions, but isnt quite truecompanies
  charge enrollment fees (adding up to the same as
  commissions).

137
PRINCIPLES OF INVESTMENT

• How to Avoid Buying Individual Stocks
• Dont buy through commission-based brokers
• Many brokerage firms advertise their market
  research, but dont produce objective reports
  on their client companies.
• Dont buy IPOs
• As a group, IPOs have historically proven to be
  poor investments. (Average return on IPO stocks
  5 percent per year, compared with 12 percent for
  comparable stocks since 1970)
• Dont day trade or short-term trade
• Some investors think they need to sell after
  short holding periods (months, weeks or even
  days) gt gambling.

138
PRINCIPLES OF INVESTMENT

• Keys to Market Success
• Dont try to time the markets (anticipating where
  the stock market and specific stocks are going is
  tough)
• Diversify (different size companies and
  industries)
• Keep trading costs, management fees, and
  commissions to a minimum (represent a big drain
  on returns)
• Pay attention to taxes (calculate your returns on
  an after-tax basis)
• Dont overestimate your ability to pick the big
  winning stocks.

139
PRINCIPLES OF INVESTMENT

• Types of Stocks
• There are two types of stocks, common and
  preferred, both representing a proportional share
  of ownership in a company
• Although called "stock," preferred stock is
  actually a hybrid between a stock and a bond.
• By buying a stock your return can be from
• Current income, if the company pays part of its
  earnings to shareholders as dividends
• Capital appreciation, if the price of its shares
  increases

140
PRINCIPLES OF INVESTMENT

• Common Stocks
• By owning a common stock, shareholders are a part
  owner of a business, and get one vote per share
  of stock to elect the board of directors. The
  board is a group of individuals who oversee major
  decisions made by the company.
• Common stock shareholders also get a full share
  of the risk inherent in operating the business.
  If things go bad, their shares of stock may
  decrease in value -- or even end up being
  worthless if the company goes bankrupt
• Common stocks give the shareholder a share in a
  companys profits (dividends)
• In case of liquidation of a company, common
  shareholders can claim the companys assets only
  after bondholders and preferred stockholders were
  paid

141
PRINCIPLES OF INVESTMENT

• Preferred Stocks
• In case of a bankruptcy liquidation, shareholders
  have claims to the assets of a company superior
  to the common stock holder, i.e. they get paid
  before common stock holders.
• Preferred stock always carries a dividend
  (usually a fixed of par value), although the
  company can elect not to pay this dividend if it
  does not have the financial resources.
• Dividends are often "cumulative, i.e. before the
  company can pay a dividend to the common
  shareholders, it must completely catch up on any
  missed dividends for the preferred shareholders.
• Preferred stocks do not appreciate as much as
  common stocks if the company that issued them
  improves financially.
• A company may also choose to "retire" its
  preferred shares, buying them back in order to
  stop paying the dividend.

142
PRINCIPLES OF INVESTMENT
Risk versus Return
Risk
Low High
PREFERRED STOCKS
COMMON STOCKS
BONDS
Low High
Return
143
PRINCIPLES OF INVESTMENT

• Direct buying from companies
• An increasing number of companies sell stock
  directly to the public.
• Proponents say that you can invest without paying
  commissions, but isnt quite truecompanies
  charge enrollment fees (adding up to the same as
  commissions).

144
PRINCIPLES OF INVESTMENT
Online Trading E.g. You have 5,000 to invest.
After doing a research, you identified General
Motors (ticker GM) as one, the shares of which
you want to buy. The last price for GM is 40.79
per share. That means you are going to buy 122
shares. The screen below shows how to place this
order online using Datek.com
145
PRINCIPLES OF INVESTMENT

• Which Online Broker is the right one for you?
• There are numerous rankings of Online Brokers
• According to the Online Broker Survey 2000,
  online brokerage companies have been ranked in
  the following order
• www.datek.com
• www.fidelity.com
• www.charlesschwab.com
• www.csfbdirect.com
• www.ameritrade.com
• www.etrade.com
• www.tdwaterhouse.com

146
PRINCIPLES OF INVESTMENT
Factors to consider when selecting an Online
Broker

Limit Orders (1 to 5,000 shares traded online) 19.95 9.99 13.00 25.00 2c/sh 1000 15.00 29.95 3c/sh 1000
Market Orders (1 to 5,000 shares traded online) 14.95 (NYSE, AMEX) 9.99 8.00 25.00 2c/sh 1000 12.00 29.95 3c/sh 1000
Real-Time Streaming Quotes (continuous update) Limited Free Unlimited NO Limited NO YES
EH in 12-Hr Trading Day NO YES NO NO NO NO
Commitment on Exec. Mkt. Orders NONE W/n 60 sec or no fee NONE NONE NONE NONE
Commission on Adtnl 5000 Shares 50.00 9.99 N/A 105.00 100.00 149.95
Initial Minimum Deposit 1,000 500 2,000 2,500 1,000 5,000
147
PRINCIPLES OF INVESTMENT

• Buying from brokers
• Many commission-based brokers advertise their
  market research, but dont produce objective
  reports on their client companies.
• You can have your own broker who will buy stocks
  for you. Usually brokers have their people on the
  floor. You can reach your broker by phone, when
  you want to buy or sell certain stocks. However,
  brokers charge much higher commissions, and
  therefore are expensive.

148
PRINCIPLES OF INVESTMENT

• Buying Mutual Funds
• Mutual funds are investment companies that
  invest money from individuals into securities,
  such as stocks and bonds.
• Advantages of Mutual Funds
• Diversification buying a mutual fund provides
  instant holdings of several different companies.
• Professional management full time money mangers
  saves time for the individual
• Liquidity like individual stocks, a mutual fund
  investment can be converted into cash upon your
  request.

149
PRINCIPLES OF INVESTMENT

• Disadvantages of Mutual Funds
• No Control Unlike picking your own individual
  stocks, a mutual fund puts you in the passenger
  seat of somebody else's car.
• Tax concerns Fund manager decides when to sell,
  sometimes with high levels of taxable
  distribution
• Dilution Generally have such small holdings of
  so many different stocks that a great performance
  by a fund's top holdings still doesn't make much
  of a difference in a mutual fund's total
  performance.
• Buried Costs Many mutual funds specialize in
  burying their costs and in hiring salesmen who do
  not make those costs clear to their clients.

150
PRINCIPLES OF INVESTMENT

• Types of Mutual Funds
• Mutual Funds come in every possible size and
  shape
• Bond Mutual Funds are pooled amounts of money
  invested in bonds
• All-in-one Funds are a mixture of stocks and
  bonds. A typical balanced all-in-one fund might
  contain about 50-65 stocks and hold the rest of
  shareholder's money in bonds. It is important to
  know the distribution of stocks to bonds in a
  specific balanced fund to understand the risks
  and rewards inherent in that fund.

151
PRINCIPLES OF INVESTMENT

• Types of Mutual Funds (continued)
• Stock Funds are pooled amounts of money that are
  invested in stocks. Stocks are often categorized
  by their market capitalization (or caps), and can
  be classified in three basic sizes small,
  medium, and large. Many mutual funds invest
  primarily in companies of one of these sizes and
  are thus classified as large-cap, mid-cap or
  small-cap funds.
• International Funds invest in non-U.S. companies
  Global Funds invest in both U.S. and
  international-based companies. In general,
  international and global funds are more volatile
  than domestic funds.

152
PRINCIPLES OF INVESTMENT

• Types of Mutual Funds (continued)
• Sector Funds invest in one particular sector of
  the economy technology financial, computers,
  the Internet. Sector funds can be extremely
  volatile, since the broad market will find
  certain sectors very attractive and very
  unattractive - often in rapid succession.
• Index Funds simply seek to match "the market" by
  buying representative amounts of each stock in
  the index, rather than paying a manager to make
  bets on individual stocks, sectors, or investment
  strategies. The key to the superiority of index
  funds is that they charge very low fees for
  providing the market's returns.

153
PRINCIPLES OF INVESTMENT

• Types of Mutual Funds (continued)
• Money Market Funds are a safe, higher yielding
  alternative to bank accounts. General-purpose
  money market funds invest in government-backed
  securities, bank certificates of deposit, and
  short-term corporate debt that the largest and
  most creditworthy companies and the U.S.
  government issue. The difference between
  investing in a banks savings account and in
  money market fund is that the latter yields
  higher rate of return.

154
PRINCIPLES OF INVESTMENT

• What is the risk of investing?
• There are two alternatives of trading stocks
• Short-term or day- trading
• Buy a share of a stock today and sell it tomorrow
• Long-terms trading
• Buy a share of a stock today and hold it over a
  period of time
• Which alternative is better and why?

155
PRINCIPLES OF INVESTMENT

• Short-term trading
• Some investors think they need to sell after
  short holding periods (months, weeks or even
  days) gt gambling
• Short-term trading is more risky than long-term
  trading
• Short-term trading takes almost an everyday
  effort of following whats happening in the
  market and take immediate measures as to which
  stocks need to be bought and which to be sold off
  portfolio
• Short-term trading is more expensive, since for
  every order you place (buy or sell)