Personal Finance

When purchasing a stock or equity position in a company you want to make a wise choice. In order to make the wise choice you must filter out what I call equity marketing noise. This means looking at a few numbers. One should look at how much cash and receivables a company has as compared to both its short and long term liabilities. Forget about all the working capital ratios, earnings per share and price earnings ratios because they often do not tell the truth.

Cash and receivables when compared to short and long term liabilities represents a company’s ability to pay now. Using inventory in the ratio does not account for recession risk, or what I call demand risk, so strip it out. How would a company pay its short term liabilities if demand suddenly decreased (can’t move inventory)? Removing other receivables from the equation is also wise because often times this number contain amounts owed by related entities that may have no ability to pay. Items such as good will should also never be included because it is intangible, or of no real value in time of a recession, let alone anytime.

One can use all the fancy math and equations you like and find that your analysis paralyzes you from making a good decision, or alters your perception. By considering the cash flow that is outlined above you reduce your risk of making a bad decision. Couple this with gross margin which is sales dollar minus direct input costs such as material and labor. Next reduce this margin by the selling, general and administrative costs. Then compare that percentage of the sales dollar to the competition. This will tell you if the executives are overpaid, if marketing and selling expenses are truly returning on investment, and if there is waste in overhead. Choosing a company with the strongest cash position, and the strongest margin after subtracting the above expenses will tell you all you need to know to make a wise decision.

Remember keep it simple.

Family financial planning is extremely important and must be approached with the proper decision making tools. The first order of business to decide on is your risk tolerance. Finding the level of acceptable risk is the number one reason people fail to reach their financial goals. An investor must understand time horizon as it relates to specific investments. Education has a shorter time horizon than retirement, therefore one would want less risk associated with shorter time horizons in normal circumstances. Gaining comfort with your time horizon and risk tolerance can directly affect your decisions to enter into or abandon an investment.

Zero debt is a great goal to start with. Next an emergency fund equivalent to three to twelve months of your annual salary is a guideline. The emergency fund should be kept at the Bank where you do your checking in an interest bearing account, perhaps laddered CD’s, or the bank money market account. Emergency fund levels should depend on your income type (commissions, salary, royalty ect). Also your emergency fund must consider the risk of your employment security. The more secure your employment and regularity of income, the less risk, consequently a lower amount of funds can be acceptable.

The next place to start is maxing out your employers offered 401K. Contributions should be made to the maximum match that the employer provides. Next consider a Roth versus a Traditional IRA. If you can do both then do it! This will minimize future taxation risk. Roth is taxed up front, traditional IRA’s are taxed when you take distributions.

Mutual funds, equites and bonds should be considered for the 401K, Roth and Traditional IRA. Also, one must consider dividends in the mix. If you do not understand an investment then do not invest in it. Bonds carry principal risk associated with timing of interest rate increases if you sell a bond prior to its’ maturity date; in other words you can find yourself selling a bond below what you paid for it.

The risk of the ups and downs of the stock market may be uncomfortable for some people. As a result, when considering stock market risk, doing what makes you comfortable and less stressed is the way to go. If you are able to deal with the ups and downs of the equity market, and maintain a happy stress free balance, then by all means the stock market is the place to invest. Remember to write down your financial goals.