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.