Understanding Investment Concepts and Financial Ratios
Understanding Investment
The term investment refers to the act of postponing the immediate benefit of an asset for the promise of a more or less probable future benefit. An investment is a limited amount of money placed at the disposal of third parties, with the purpose of increasing the profits generated by that business project.
Key Elements of Investment
An investment involves several elements:
- One subject (the investor)
- A financial asset
- The renunciation of immediate satisfaction
- An asset in which you invest
- A promise of a more or less uncertain future reward
An investment is financial when the money is used to acquire assets whose price depends on the income they are expected to generate in the future, such as company shares, fixed-term deposits, and debt.
Investment Risk and Opportunity
Every investment involves both a risk and an opportunity. It is a risk because the return on the money we invest is not guaranteed. It is an opportunity because the money invested can be multiplied.
Four Key Investment Variables
Four different but related variables must be considered in any investment:
Expected Return
The return we expect to obtain on our investment, usually measured as a percentage of the amount invested. There is a direct relationship between expected return and the risk assumed: the higher the return, the higher the risk.
Accepted Risk
The uncertainty about the return and the possibility of not recovering the money invested. This is a very subjective variable and defines the investor’s profile and risk aversion. A conservative investor will tend to invest in low-risk and therefore lower-return products, such as public debt or fixed-term deposits, even if the interest is lower than what could be obtained from other investments.
Time Horizon
The time horizon of the investment, which can be short, medium, or long term. Longer-term investments tend to offer higher interest rates than shorter terms. A clear example is Treasury bills (3-18 months) versus government bonds (3 to 5 years).
Liquidity
How quickly we can recover our investment and at what cost if needed.
Savings vs. Investment
The main difference concerns risk. While savings can be kept at home or in a bank deposit, practically risk-free, deciding to invest implies expecting a profit, which involves risk. The rule is: the higher the potential profit, the greater the risk.
Understanding Investment Funds
Investment funds are Collective Investment Institutions whose purpose is to attract contributions from a variable number of investors, in order to manage them with the objective of obtaining a profit with adequate diversification of risk. Unitholders own a portion of the fund’s assets in proportion to the value of their contributions.
Structure of Investment Funds
Lacking legal personality, an investment fund interacts with the environment through two entities:
- The Management Company: Jointly invests contributions in different financial assets following guidelines set out in the fund’s investment policy.
- The Custodian Company: Holds the fund’s assets and assumes certain control functions over the Management Company for the benefit of the unitholders.
Advantages for the Small Investor
Investment funds offer several advantages for the small investor:
Diversification
Through an investment fund, you can spread your money across different assets, sectors, and markets with varying behaviors in the same market situation. If any asset generates losses, these can be offset, at least in part, by gains from others.
Access to Numerous Markets
You gain access to markets that might not be available if you were investing individually.
Efficiency
By investing collectively, funds leverage economies of scale, incurring lower costs when operating in the markets.
Professional Management
Investing in funds means entrusting part of your savings to a professional team with greater capacity for analysis and market monitoring than a retail investor.
Suitable Products for Each Profile
There is a wide range of fund types, allowing you to find products for any investor profile, from the most conservative to those willing to assume greater risks.
Market Fluctuations
Remember that like any financial instrument, investments in funds are subject to market fluctuations and the risks inherent in investing.
Understanding Vulture Funds
A vulture fund is a private equity or investment fund that invests in the public debt of an entity considered close to bankruptcy. According to journalist Alcadio Oña, the modus operandi of vulture funds is to buy the debt of states and companies on the verge of bankruptcy on the market, at a percentage much lower than their nominal value, and then litigate or press for payment of 100% of this value. Through financial speculation, vulture funds buy debt of countries in a difficult economic situation at a very low price and then litigate in international forums to try to collect the full value of these bonds.
Fixed vs. Variable Income
- Rent can be defined as the flow of income received for the use or rental of a productive factor, including capital and labor.
- Salary is an example of labor income, while income derived from investments is an example of capital income.
- In the investment world, capital income is usually classified into fixed income and variable income.
- Fixed income is an investment in a financial instrument where, at the time of contracting, you know the profitability it will provide for maintaining it over a determined period. By investing in fixed income, you lend your money knowing you will get it back later, possibly receiving a bonus during this time.
- Variable income is an investment in a financial instrument that provides an undetermined income over an indefinite period. By investing in variable income, you become the owner of an asset, enjoying the rights of ownership while assuming the risk due to uncertainty in the asset’s future evolution.
Key Financial Ratios
Financial ratios are metrics used to assess a company’s performance and health.
Treasury Ratio
The numerator is the cash the company has or can access short-term; the denominator is the daily average current expenses (often divided by 360). The result indicates the number of days of expenses the company can cover. The numerator (cash, short-term investments) is relatively controllable, but the denominator (Cost of Goods Sold, general expenses) is more complex as these cannot be easily reduced if the company is to continue operating. A very high ratio is good for security but not for profitability (cash isn’t working). A very low ratio is bad for security but potentially good for profitability (cash is invested). The appropriate ratio depends on the company and sector.
Liquidity Ratio
Similar to Working Capital (current assets minus short-term liabilities). Its management depends on various roles (treasurer, warehouse manager, etc.).
Solvency Ratio
Indicates the portion of assets financed by equity (own funds). A low ratio can be good for profitability.
Debt Ratio
Indicates the portion of assets financed by debt. Companies can set control objectives for this ratio. Generally, higher indebtedness can lead to higher profitability but also higher risk.
Interest Coverage Ratio
Indicates how many times Profit Before Taxes can cover interest payments. This is a control ratio. The interest rate cost itself is not shown. The ratio increases significantly when interest rates rise; reducing debt can lower it.
Coverage of Financial Expenses
Explains how many times annual profits can cover the year’s debt payments (principal and interest). Cash flow after taxes is typically used for: Repaying annual loan principal, Paying dividends, Making investments. Companies often maintain a permanent level of debt if its cost is lower than the profitability generated. This permanent debt level should be manageable under normal conditions.
Customer Collection Ratio
Measures the average number of days to collect payments from customers. This is a control ratio. A low ratio is good for both profitability and risk management. Analyzing it by customer type can be insightful.
Suppliers Payment Ratio
Measures the average number of days to pay suppliers. A higher ratio can indicate higher profitability and lower risk, as financing from suppliers is often cheap and stable. Negotiating favorable payment terms and adhering to them is important, as suppliers manage their cash flow based on these agreements.
Stock Turnover Ratio
(Numerator and denominator should be at cost price). Indicates how efficiently a company manages its inventory to meet sales needs. Higher turnover means less ‘dead’ stock, which is good for profitability, but carries a higher risk of stockouts. A low ratio means a lot of capital is tied up in stock, negatively impacting profitability. This ratio is influenced by company policy.
Working Capital to Sales Ratio
Indicates Working Capital as a percentage of sales. Working Capital represents short-term assets minus short-term liabilities, reflecting short-term liquidity.
Return on Sales (ROS)
A percentage indicating profit earned for each euro of sales. Higher ROS signifies better profitability.
Return on Assets (ROA)
Measures how effectively a company uses its assets to generate profit.
Asset Turnover Ratio
Measures how efficiently a company uses its assets to generate sales.
Return on Equity (ROE)
Often considered a key ratio. It shows the profit generated relative to shareholders’ equity. Investors typically demand a higher ROE for companies with higher risk.
Du Pont Analysis
A framework that breaks down ROE to analyze how a company generates returns. Useful for understanding a company’s business model and benchmarking against competitors.