OM

Finance Concepts and Ratio Analysis

Fractional Reserve Banking in Canada

  • Concept of Money

  • Money is defined as debt in this context, implying it is a bank's liability.

  • Money is created when banks issue loans, serving as a promise to pay.

  • Bank balances are essentially IOUs from banks, emphasizing the importance of trust within the financial system.

  • Money Creation Process (Government to Central Bank)

  1. Money Printing
    • Modern economies primarily create money digitally, rather than physically printing it.
    • Central banks (e.g., Bank of Canada) raise the reserves in the banking system.
  2. Government Injection into Banks
    • The government adds money into banks through public spending on projects, salaries, or social benefits.
    • Treasury bills (T-bills) or bonds are issued to raise funds for the government, subsequently depositing this money into banks.
  3. Banks and Central Bank Interaction
    • Banks keep a portion of their money as reserves with the central bank (due to requirements or interest benefits).
    • Banks may also lend money back to the government by purchasing T-bills.
    • To control inflation, the central bank can sell T-bills, absorbing excess money from circulation.

  • Risk of Bank Runs

  • Banks do not maintain all deposits as cash; they lend most of it.

  • A bank run occurs when too many customers demand their deposits at the same time, which may lead to a collapse if insufficient cash is available.

  • Unsecured Creditors

  • Unsecured creditors lack specific assets to claim in case of borrower default and are settled after secured creditors in bankruptcy cases.

Ratio Analysis in Finance

  • Categories of Ratios

  • Profitability Ratios: Evaluate income relative to equity.

  • Liquidity Ratios: Assess the ability to cover short-term liabilities.

  • Debt Ratios: Determine financial leverage by comparing debt to equity.

  • Asset Activity Ratios: Measure how effectively assets are utilized.

  • Market Value Ratios: Analyze performance relative to market price.

  • Key Ratios

  • Return on Equity (ROE):

    • Formula: ROE = Net Income / Common Equity

  • Current Ratio:

    • Formula: Current Ratio = Current Assets / Current Liabilities

  • Acid-Test Ratio:

    • Formula: Acid-Test Ratio = (Current Assets - Inventory) / Current Liabilities

  • Debt to Equity Ratio:

    • Formula: Debt to Equity Ratio = Total Debt / Common Equity

  • Times Interest Earned Ratio:

    • Formula: Times Interest Earned = Operating Income / Interest Expense

Bond Valuation

  • Intrinsic Value Calculation

  • Use formula for present value (P0), considering factors like dividend growth (g), required rate of return (ks), and last dividends paid (D0).

  • When to Trade Stocks

  • Buy: Intrinsic value > Market price (undervalued)

  • Sell: Intrinsic value < Market price (overvalued)

  • Hold: Intrinsic value ≈ Market price (fairly valued)

  • Finding Key Values

  • D0 can be calculated from a provided percentage of dividends.

  • ks can be determined using CAPM.

  • g can be derived using Time Value of Money (TVM) functions.

Valuation Techniques

  • Establishing True Price

  • Price negotiation is influenced by perceived value and market demand; true price varies among parties.

  • WAC (Worth After Consideration)

  • Formulaic approach: WAC = CF / Risk

    • CF: Represents cash flow from an asset.
    • Risk: The rate discounting future cash flows based on uncertainties.

  • Three Components of Valuation

  1. Size of Cash Flow: Larger cash flows enhance value.
  2. Timing of Cash Flow: Early cash flows are more valuable due to time value of money.
  3. Risk of Cash Flow: Higher risks necessitate higher discount rates.

  • Discounted Cash Flow Model

  • DCF values private companies through estimating future cash flows and discounting to present value reflecting risk.

  • Required Rate of Return (CAPM):

  • Formula: r = Krf + β(Km - Krf)

    • Krf = risk-free rate
    • β = beta (risk measure)
    • Km = expected market return

Psychological Factors in Investing

  • Fear and Greed

  • Fear: Drives rapid selling by investors, lowering asset prices.

  • Greed: Elicits hasty buying, increasing asset prices.

  • Market Signals

  • Fear as a Buying Signal: Low prices create undervalued purchase opportunities.

  • Greed as a Selling Signal: High prices create overvalued asset conditions for selling.

Working Capital Management

  • Net Working Capital (Net WC) vs. Change in Working Capital (Change in WC)
  • Differentiating between operational liquidity and shifts in operational efficiency over time.