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Analyzing Investments
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“The numbers tell a story, ” my rich dad would say. “If you can learn to read financial statements you can see what is happening within any company or investment.”

My rich dad taught me how he used financial ratios to manage his businesses. Whether it is an investment in the stock of a company or purchase of real estate I always analyze the financial statements. I can determine how profitable a business is, or how highly leveraged a business is, just by looking at its financial statements and calculating financial ratios.

For a real estate investment, I calculate what the cash on cash return will be based on the amount of cash I need to spend for the down payment. But the bottom line always came back to financial literacy. This chapter will cover some of the important thought processes every sophisticated investor goes through in choosing investments for their financial plan:

Financial Ratios of a Company

Financial Ratios of Real Estate Natural Resources

Is It Good Debt or Bad Debt? Saving Is Not Investing

Financial Ratios of a Company

Gross Margin Percentage = Sales - Cost of Goods Sold Sales

The Gross Margin Percentage is the Gross Margin divided by Sales, which tells you what percentage of sales is left after deducting the cost of goods sold. Sales minus the cost of the things sold { “Cost of Goods Sold” } is called the Gross Margin. I remember rich dad saying, “if the gross isn't there, there'll be no net (income). ”

How high the Gross Margin Percentage needs to be depends on how a business is organized and the other costs it has to support. After calculating the gross margin percentage, rich dad's convenience stores still had to rent the building, pay the clerks, the utilities, the taxes and government permit fees, pay for wasted or damaged goods, and a long list of other expenses, plus have enough left over to give rich dad a good return on his original investment.

For Internet e-commerce sites today, these additional costs are usually much lower, so these businesses can afford to sell and make a profit with a lower Gross Margin Percentage.

The higher the gross margin the better .

Net Operating Margin Percentage = EBIT

Sales

The Net Operating Margin Percentage tells you the net profitability of the operations of the business before you factor in your taxes and cost of money. EBIT stands for Earnings Before Interest and Taxes, or Sales minus all costs of being in that business, not including capital costs (Interest, Taxes, Dividends).

The ratio of EBIT to Sales is called the Net Operating Margin Percentage. Businesses with high Net Operating Margin Percentages are typically stronger than those with low percentages.

The higher the net operating margin the better.

Operating Leverage = Contribution

Fixed Costs

Contribution is the name for Gross Margin (Sales less Cost of Goods Sold) minus Variable Costs (all costs that are not Fixed Costs are Variable and will fluctuate with sales) . Fixed costs include all sales, general, and administrative costs that are fixed and do not fluctuate based on sales volume. For instance, the labor costs related to full-time employees, and most costs related to your facilities, are generally considered fixed costs . Some people refer to this as “overhead.”

A business that has an operating leverage of 1 means that the business is generating just enough revenue to pay for its fixed costs. This would mean that there is no return for the owners.

The higher the operating leverage the better.

Financial Leverage = Total Capital Employed (Debt & Equity) Shareholders' Equity

Total Capital Employed is the book or accounting value of all interest bearing debt (leave out payables for goods to be resold and liabilities due to wages, expenses and taxes owed but not yet paid), plus all owners equity. So if you have $50,000 of debt and $50,000 of shareholder's equity, your financial leverage would be 2 (or $100,000 divided by $50, 000).

Total Leverage = Operating x Financial Leverages

The total risk that a company carries in its present business is the multiple of its Operating Leverage and its Financial Leverage. Total Leverage tells you what total effect a given change in the business should have on the equity owners (common shares or General Partner) . If you are the business owner, and therefore on the inside, your company's Total Leverage is at least partly under your control.

If you are looking at the stock market, Total Leverage will help you decide whether you want to invest. Well run, conservatively managed (publicly traded) American companies usually keep the Total Leverage figure under 5.

Debt to Equity Ratio = Total Liabilities

Total Equity

The Debt to Equity Ratio measures just that, the portion of the whole enterprise [Total Liabilities] financed by outsiders in proportion to the part financed by insiders [Total Equity] . Most businesses try to stay at a ratio of one-to-one or below. Generally speaking, the lower the debt-to-equity ratio the more conservative the financial structure of the company.

Quick Ratio = Liquid Assets

Current Liabilities

Current Ratio = Current Assets Current Liabilities

The significance of the quick and current ratios is that they tell you whether or not the company has enough liquid assets to pay its liabilities for the coming year. If a company doesn't have enough current assets to cover its current liabilities, it is usually a sign of impending trouble. On the other hand a current ratio and quick ratio of 2 to 1 is more than appropriate.

Return on Equity = Net Income

Average Shareholders' Equity

The Return on Equity is often considered one of the most important ratios. It allows you to compare the return this company is making on its shareholder's investment compared to alternative investments.

What Do the Ratios Tell Me?

My rich dad taught me to always consider at least 3 years of these figures. The direction and trend of Margin Percentages, Contribution Margin, Leverages and Returns on Equity tell me a lot about a company and its management and even its competitors.

Many published company reports do not include these ratios and indicators. A sophisticated investor learns to calculate these ratios (or hires someone knowledgeable to do so) when they aren't provided.

A sophisticated investor understands the terminology of the ratios and can use the ratios in evaluating the investment. However, the ratios cannot be used in a vacuum. They are indicators of a company's performance. They must be considered in conjunction with analysis of the overall business and industry. By comparing the ratios over at least a three-year period as well as with other companies in the same industry, you can quickly determine the relative strength of the company.

For example, a company with excellent ratios over the last three years and strong profits could appear to be a sound investment. However , after reviewing the industry you find out that the company's main product has just been rendered obsolete by a new product introduced by the company's main competitor. In this instance, a company with a history of strong performance may not be a wise investment due to its potential loss in market share.

While the ratios may appear complicated at first, you will be amazed at how quickly you can learn to analyze a company. Remember these ratios are the language of a sophisticated investor . Through educating yourself on financial literacy, you too can learn to “speak in ratios. ”

While the ratios may appear complicated at first, you will be amazed at how quickly you learn to analyze a company.

Investing in Real Estate: Financial Ratios for a Piece of Real Estate

When it came to real estate, rich dad had two questions.

1. Does the property generate a positive cash flow?

2. If yes, have you done your due diligence?

The most important financial ratio of a piece of real estate to rich dad was his cash on cash return.

CASH on CASH Return = Positive Net Cash Flow Down Payment

Let's say you buy an apartment building for $500, 000. You put $100, 000 down and secure a mortgage for the $400, 000 balance. You have a monthly cash flow of $2,000 after all expenses and mortgage payment are paid. Your cash on cash return is 24% or $24,000 ($2,000 x 12 months) divided by $100,000.

Before buying the apartment building, you must decide how you will purchase it. Will you buy it through a C-corporation, an LLC Corporation, or a limited partnership? Consult with your legal and tax advisors to make sure that you choose the entity that will provide the most legal protection and tax advantages to you.

Due Diligence

In my opinion, the words due diligence are some of the most important words in the world of financial literacy. It is through the process of due diligence that a sophisticated investor sees the other side of the coin. When people ask me how I find good investments I simply reply, “I find them through the process of due diligence.” Rich dad said, “The faster you are able to do your due diligence on any investment, regardless if it is a business, real estate, a stock, mutual fund or bond, the better able you will be to find the safest investments with the greatest possibility for cash flow or capital gains.

In the audio cassette learning program entitled Financial Literacy: How Sophisticated Investors Find the Investments That Average Investors Miss is a workbook filled with very sophisticated due diligence forms that can be adapted to evaluate many investments quickly. If you would like to find out more about this audio educational program and work book, please refer to our website, www .richdad.com. Not only will you listen to very sophisticated investors share their investment secrets, you will learn how to use these due diligence forms. These rarely publicized due diligence forms have the power to not only make you a more sophisticated investor, the forms can save you a lot of time analyzing investments, and they may also help you find the high yielding investments you have been looking for .

For example, once you have determined that a piece of real estate will generate a positive cash flow for you, you still need to perform due diligence on the property.

Rich dad had a checklist that he always used. I use a due diligence checklist created by Cindy Shopoff. It is very thorough and includes items that did not exist 30 years ago (eg. Phase I Environmental Audit). I have included Cindy's checklist as a reference for you.

If I have questions about the property, I often bring in the experts and have my attorneys and accountants review the deal.

Due Diligence Checklist

1. Current rent roster with paid to dates

2. List of security deposits

3. Mortgage payment information

4. Personal property list

6. Insurance policy, agent

7. Maintenance, service agreement

8. Tenant information: leases, ledger cards, applications, smoke

detector forms

9. List of vendors and utility companies, including account number

10. A statement of structural alterations made to the premises

11. Surveys and engineering documents

12. Commission agreements

13. Rental or listing agreements

14. Easement agreements

15. Development plans, including plans and specifications and as-built architectural, structural, mechanical, electrical and civil drawings

16. Governmental permits or zoning restrictions affecting development of the property

17. Management contracts

18. Tax bills and property tax statements

19. Utility bills

20. Cash receipts and disbursements journals pertaining to the property

21. Capital expenditure disbursement records pertaining to the property

for the past five years

22. Income and expense statements pertaining to the property for two

years prior to the submission date

23. Financial statements and state and federal tax returns for the

property

24. A termite inspection in form and content reasonably satisfactory to

the buyer

25. All other records and documents in Seller's possession or under Seller's control which would be necessary or helpful to the ownership, operation or maintenance of the property

26. Market surveys or studies of the area

27. Construction budget or actuals

28. Tenant profiles or surveys

29. Work-order files

30. Bank statements for 2 years showing operating account for property

31. Certificates of occupancy

32. Title abstract

33. Copies of all surviving guarantees and warranties

34. Phase I Environmental Audit (if exists) For Every Investment

Many sophisticated investors include investments in the earth's natural resources as part of their portfolio. They invest in oil, gas, coal and precious metals, just to name a few.

My rich dad strongly believed in the power of gold. As a natural resource, gold has a limited supply. As rich dad told me, people throughout the centuries have cherished gold. Rich dad also believed that owning gold attracted other wealth to you.

Is It Good Debt or Bad Debt?

A sophisticated investor recognizes good debt, good expenses and good liabilities. I remember rich dad asking me, “How many rental houses can you afford to own where you lose $100 per month?” I, of course answered, “Not too many.” Then he asked me, “How many rental houses can you afford to own where you earn $100 per month?” The answer to that question is, “as many as I can find!”

Analyze each of your expenses, liabilities and debts . Does each particular expense, liability or debt apply to a corresponding income or an asset? If so, is the resulting cash flow in from the income and/or asset greater than the cash flow out for the expense/liability/debt?

For example, a friend of mine, Jim, has a mortgage on an apartment building for $600,000, for which he pays out $5,500 each month in mortgage and interest payments. He receives rental income from his tenants of $8,000 each month. After all other expenses he has a net positive cash flow of $1,500 each month from that apartment building. I would consider Jim's mortgage a GOOD DEBT.

Saving Is Not Investing

A sophisticated investor understands the difference between saving and investing. Let's look at the case of two friends, John and Terry, both of whom believe themselves to be sophisticated investors.

John is a highly paid professional and invests the maximum in his 401(k) retirement plan at work. John is 42 and has $250,000 in his 401(k) plan already because he has been adding to it for 11 years. There is no return, or cash flow, from it until he retires and then it will be fully taxable at his regular earned income rates.

John's details :

Earning $100,000 salary

Taxes - assume average rate of 25% (low) Investment - Pension Plan - 401(k) Maximum 15% contribution or $15,000 Pension Plan - earns 8% per year Current Cash Flow from investments - none

Terry is the same age as John and makes a similar salary. She has invested in a series of real estate deals over the past 11 years and just put $250,000 down on a $1,000,000 property. Terry is earning a cash on cash return of 10% and expects a conservative appreciation of her property of 4% per year. When she retires, Terry expects to 1031 Exchange into another property to take advantage of the high equity and cash flow. Terry has never contributed to the 401(k) plan and the income from her property is taxed currently.

Terry's details :

Earning $100,000 salary

Taxes - assume average rate of 25% (low)

Investment - Buy Real Estate at $1,000,000 with 25% or $250,000 down

Property - earns 10% cash on cash return Appreciates 4% per year

Current Cash Flow - $25,000 per year from Real Estate investment

The following chart shows the asset accumulation, annual after taxes cash flow available for spending, and the annual retirement cash flow (also after taxes) for both John and Terry. I thank my tax advisor, Diane Kennedy, CPA for preparing this analysis so I could share it with you.

Beginning yrs 1 - 19

Assets Cash Flow Invests Cash Flow

John $250,000 $63,750 $15,000 $63,750

Terry $250,000 $73,560 0 $73,560

At 20 years Annual Retired

Assets Cash Flow Net Cashflow

John $1,968,000 $63,750 $118,100

As you see, Terry's family will be able to spend almost $10,000 more per year than John's family, each and every year for the next 20 years. After which, they both retire at age 62, having worked 31 years.

At retirement, John begins drawing out 8% of his accumulated 401(k) plan, receiving $118,100 per year ($157,400 before taxes). He plans to withdraw none of the principal amount. He succeeded, after 31 total years of investing $15,000 in his plan each year, in replacing 150% of his work income.

Even though Terry had only put $250,000 down on the property, she benefited from the 4% appreciation on the total $1,000,000 value of the property. During the 20 years, the rental income from the property paid off the mortgage of $750, 000, so when Terry retires she can roll over the complete equity of $1,000, 000 into a much larger property (worth $8, 892,000 according to these calculations) . This new property will generate a cash flow of $342,700 per year for Terry.

While John's retirement will be comfortable, Terry's will be rich.

If, for some reason, John needs more income in retirement, he must start drawing out the principal from his retirement plan. Terry would only need to do another tax-free exchange into other buildings to capture the mortgage principal paid down by her tenants, leveraging that into higher income.

John's example will have taught his children to go to school, get good grades, get a good job, work hard, “invest” in the retirement plan regularly; and as a result, be comfortable in retirement.

Terry's example will have taught her children that if they learn how to invest by starting small, to mind their own business, and to keep their money working hard for them, they'll be rich.

It is easy to see that investing in a building generated much more cash flow and income for Terry than saving in his 401(k) did for John. I would categorize Terry as an investor and John as a saver .

A sophisticated investor understands the difference between investing and saving and generally has both as part of his or her financial plan.

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