Trade The Journey

Trade The Journey

Ratios

In college, I remember taking courses in statistics, economics, history and corporate finance. Some of the material I remember and some I have forgotten. The more I learn, the more I see I should have paid closer attention to the lessons being conveyed. Had I would have been paying attention, I would know the significance of the Franco-Prussia war in establishing  a gold standard when France became indebted to Germany after losing the war.

I would know the reason that US abandoned the gold standard when countries begin to call in their gold with the dollars they held because of the volatility of the US dollar. This caused the dismemberment of the Breton-Woods agreement. We live and we learn. Math is the heartbeat of the financial market and if you have a hard time with it, you could have a hard time doing well in investing. I say “could” because there are different methods and strategies that can produce positive results but Math will always be there in some form. Adding and subtracting is required in order to arrive at the numbers needed for analysis. However, “ratios” are what are going to give you a edge in completing analysis regarding the different companies.

Ratios involve comparing numbers such as the debt to equity, cost to sales, etc. Here is a problem  to test your ratio knowledge:

There was a inheritance left to you by your grandmother to the amount of $100,000. Your grandmother decided to base the ratio on points she used to assess your achievements. Grandmother was shrewd. Based on the score, you were assessed a 5 and your cousin a 3. So the ratio would be a 5:3. How much would each person receive?

  1. There are a total of 8 parts that the $100,000 must be divided into.
  2. $100,000 /8= $12,500
  3. You the better performing grandchild would receive $62,500 and the lesser performing could would receive $37,500.
  4. If you add those two numbers together, you are back at the $100,000.
  5. We could complete another ratio comparing $62,500 to  $37,500  (1.66:1) or $37,500 to $62,500.(0.6:1) Or what about the $62,500 to $50,000. If our Grandmother was fair, we’d paid $50,000 which would be a 1:1 ratio. $50,000 to $50,000.

Ratios are very important and you can use them to compare the numbers on the financial statements to other companies, to the industry standards and to forecast where the company might be going. Margin is another term you should familiarize yourself with. It is the amount by which something falls or wins defined by the dictionary.

Here is a simple income statement which allows us to see the cost associated with producing the product or service and the general expenses incurred from running a business.

We start off with our Sales which is $250,000. We then can look at the cost of goods which is $90,000 and do a ratio analysis. But before we do that, we could go beyond the numbers and begin to analyze what the numbers are telling us. How is the inventory being calculated is it?Is it First-in-First-Out, which assumes that the first received is the first sold. Which means that the balance sheet reflects the current cost of inventory and the income statement the historical cost of inventory. This means that the inventory listed above could be at a lower or higher cost which affects the gross margin which in turn affects the profitability.

Cost of goods to sales/Revenue. $9,000 to $250,000. The total is 3.6%. Which means that Cost of Good Sold is 3.6% of the Revenue. In the upcoming series on Financial Statements. I’ll be going through the different financial statements throughout this week in detail as well as the financial profitability ratios that will help me and you become better investors/traders.

The goal is to become a intuitive investor.

Stay Tuned.

Leave a Comment

Your email address will not be published. Required fields are marked *