Welcome to my page of Investment definitions!
Here you will learn the nitty gritty details that will help you to assess whether an investment is a 'beauty' or a 'beast'. I'm sorry in advance for this, but if you aren't aware, as sexy as investment may sound and be, it is a numbers game. The Tao of Investing (if such a thing exists) is the Way of the Accountant!!!
Let us start with the basics. What is 'Profit'?
Profit is a fairly general description. There are actually a number of types of profit and they all have different meanings and uses to the investor.
Operating profit is earned from the manufacture of goods or the providing of services. This means that it is before overhead costs, R&D and other sources of gains or losses.
operating profits = sales (turnover) - direct costs
This takes into account indirect costs. These might include interest being paid on loans or the costs of central management. Equity analysts will focus on this figure for business vs business comparison.
pre-tax profit = operating profit - indirect costs
Net of Tax Profit
Net of tax profit is the profit after tax has been deducted. The rates of tax to be paid will vary from company to company. This may be because of overseas interests or differing capital expenditure levels.
net of tax profits = pre-tax profits - taxation
These are profits left after all costs have been deducted and are therefore available for shareholders. Often these will be the same as net of tax profits, though in some cases there will be 'minority interests'. These occur where a subsidiary is partly owned by another person or firm.
attributable profit = net of tax profit - minority interests
This amount is left after any dividends have been paid to shareholders. The money is therefore 'retained' by the company for future investment. The money will initially be placed in the company reserves.
retained profit = attributable profits - dividends paid out
Earnings per share
This is a widely used number because it describes a company's post-tax profits per ordinary share. This makes it far easier for the investor to understand and use as a comparison figure.
earnings per share (EPS) = attributable profits - preference dividends divided by the number of shares in issue
There are two liquidity ratios that are generally used to offer an insight into the liquidity of the firm. These are the Current Ratio and the Quick Ratio.
Current ratio = Current assets / Current liabilities
Current liabilities are generally defined as any that need to be settled within 12 months. Current assets can be essentially reduced to cash, stock and any debtors.
The current ratio is designed to be a broad guide. As with most ratios, the results cannot be readily compared with any other firms or industries as for obvious reasons, every one is different. It is accepted that a ratio of between 1.5 and 2.0 is prudent.
However, a high ratio can be a bad thing. Whilst it may show careful financial management, it may also suggest that assets could be used more profitably and the company holds too much cash or inventory.
Quick ratio = (Current assets - stock) / Current liabilities
The quick ratio is designed to show how much could be instantly realisable into cash. The thinking is that if all debts needed to be settled tomorrow or next week, could they be? A result of less than 1 suggests that the debts could not be settled at short notice.
These liquidity ratios can only offer a guide to the financial state of a firm. They can only be taken as a part of the whole. However, as with any analysis, they can highlight potential financial problems in the future.
Astute or more experienced readers may be scratching their heads as this point. After all, it is important to bear in mind that a company does not pay it's bills or debts by using a quick ratio! Companies pay their bills with cash and so understanding the cash flow is likely to be more important to most people. These ratios really only come into play when a company is in very serious financial trouble - by definition this is not the best place to look for long-term investing profits.
However, if times really are that bad for the company you are invested in, this handy tool will help you to work it out quickly.
Other pages of interest are:
How To Use Risk Analysis To Make You A Better Investor
What Does The Return On Capital Employed (ROCE) Tell Us?
What Is Alpha? Can You Outperform The Stock Market?
Learn How Beta And Volatility Impact Your Investment Portfolio
Understanding Different Types Of Risk
Why Low Risk Can Be Good
What Is A Stop-Loss?
Why Selling Investments Is THE Most Important Skill You Can Learn In Investing
Understanding A P/E Ratio (Price To Earnings Ratio)
Understanding Gearing And Borrowed Money
How Does Volatility, Standard Deviation and Beta Impact An Investment Portfolio?
Does Correlation Influence Portfolio Diversification?