If you do Financial Modeling you have to have some understanding of Accounting.
Here are some ratios that you need to know. They are part of the “survival kit”
Working Capital:
The Working Capital is the difference between the Current Assets and the Current Liabilities.
So: Working Capital = Current Assets – Current Liabilities
The Current Liabilities are the debt to be paid within the year.
The Cash Flows used to repay the debt come from the Current Assets.
Thus, the Working Capital is what is left to the company if all current debts are paid.
Generally companies with a comfortable Working Capital attract conservative investors as they are less likely to default.
Noting an increase in the Year-to-Year Working Capital is a sign the company is growing and doing well.
Quick Ratio:
The Quick Ratio you have to divide Current Assets by Current Liabilities.
So: Quick Ratio = Current Assets / Current Liabilities
What’s so different with the Working Capital then?
- A ratio is easy to understand and facilitates the comparison with companies in the same sector.
- A ratio of 2 to 1 is usually considered adequate (well: it really depends on the sector you are studying though)
for instance a ratio of 3.5 would mean that for $1 in debt, the company has $3.5 to back it up.
Quick Assets:
The Quick Ratio is easy to use and gives you a broad idea of the financial standing of a company. But the Current Assets take into consideration non liquid assets. Understand here Assets that cannot be converted in cash instantly. The Quick Assets “corrects” the Current Assets by removing illiquid assets.
Quick Assets = Current Assets – Illiquid Assets
Where Illiquid Assets are Inventory, Prepaid Expenses…
Quick Assets Ratio:
Now we have removed the Illiquid Assets of the Current Assets we can also calculate the Quick Assets Ratio.
Quick Assets Ratio = Quick Assets / Current Liabilities
This ratio gives a better representation of the financial standing of a company.
Debt to Equity:
A certain level of debt is acceptable but how much is too much?
Debt to Equity = Total Liabilities / Total Shareholder’s Equity
For instance, a Debt to Equity of .86 would mean that for every $1 in Equity the company has contracted a Debt of $.86
Depending on the Industry this Ratio can differ. Industrial Companies will try to remain below the 1-to-1 mark whereas Startups, Financial Companies or Services Companies will operate with a much higher ratio.
Hope this helps…
To be continued!
