8 Financial Ratios Every Smart Investor Must Master | Ep 93

Speaker: I gotta be honest, if you're really into math, you're gonna love this episode. And if you're not into math, you should still hang on because Jessi isn't into math. That's true. And she's here, so you gotta give her support. I suppose because math is really important when you're looking at evaluating real estate, which is what we're going to do on the Furlo Capital Real Estate Podcast, where we dive into the intricacies of passive real estate investing.

And our mission is to equip people to invest wisely, often with a lot of math so that together. We can build wealth while improving housing. I'm James, and this is my wife, Jesse.

Speaker 2: Well, that changed my intro. I had something different, but I think this is appropriate because Eleanor came home from school and she told me it was a great day.

I was like, oh, that's so good. I'm so glad that it was, she was like, yeah, we didn't have math.

Speaker 3: Ah, yeah. Yeah. So

Speaker 2: she kind of you know, always after me, Samson does like math,

Speaker: but. It's all right. You know, it's okay. You don't have to, you don't have to love it. But I, yeah. I don't have to

Speaker 2: love it, but I use it almost every day.

Speaker: So Yeah. If you're going to invest, it's really important Yeah. To know the math. That's true. And I actually pulled this article from something that Robert Kiyosaki wrote, my Personal Hero, and you know, and, and he kind of framed it where he was like, well, you know, like. A lot of investors, they're just flying blind and they don't do any math at all.

And like, that's not good when, which I'm like, ah, I dunno if that's a hundred percent true, but I do think there's a lot of like high level numbers Sure. That investors tend to rely on. Yeah. There's some

Speaker 2: estimates.

Speaker: Yeah. And, and the numbers that I'm gonna share are more I'm gonna say like. Business focus as opposed to specific to real estate focused.

But I still think they're really good to know because the better you understand these, the better you are at just evaluating a business. Mm. In general. Okay. And so that's what, that's what we're gonna talk about. I will trust you today

Speaker 2: that math is important. So we're

Speaker: gonna go over eight ratios.

Speaker 2: Eight ratios,

Speaker: and that's the thing like, those, like the high level numbers, like revenue Sure. Right. Is a, is a high level number. But what's ratios are interesting because they're often comparing and contrasting two different measures. Yeah. And so it's just a, it's a deeper way of helping you evaluate the business.

Right. It's like, I remember in physics there was a big difference between talking about speed and then there was acceleration. Mm-hmm. And then there was the actual derivative of that, which was the change of the acceleration.

Speaker 2: Right? Sure. Yeah, sure.

Speaker: You're getting faster, but are you getting faster, faster or faster?

Slower, Uhhuh. Yeah. So and ratios, that's not a perfect analogy, but ratios are kind of like that where they help you not just see those top level numbers, but like how they interact. Yeah. And it gives you insights in how the business is doing because on the surface it might look great. Like revenue might be like, oh my gosh, revenue's huge.

Mm. Like, well, yeah, but maybe compared to so are costs. Yeah. And so, you know, is it that great? Yeah.

Speaker 2: That it kind of reminds me of, some of those things of like, it doesn't, it doesn't matter how much money you make if you're spending all of it.

Speaker: Yeah. You

Speaker 2: know, it's like, yeah. You could be an ultra uber millionaire and if you spend that much, you still have zero.

Speaker: Yeah. Yeah. It's just like, no, it, it, or ratio matters. So the very first one actually is very similar to that. It's just your gross margin percentage. Mm-hmm. Right? Which is essentially, so it's not just your gross margin, which I think a lot of people focus on. Oh, but it's the, the percentage of that percentage.

So it's your gross margin, which is your sales, minus expenses divided by sales.

Speaker 2: Okay.

Speaker: Okay. So that's where, why,

Speaker 2: why would you want that as opposed to just. Sales minus expenses,

Speaker: Because again, it kinda gives you that ratio of like, hey, like as our profit margin like is that a good number or is that a bad number?

Like, for example let's say that you've got you could have, you could have the same gross margin of a hundred dollars. Mm-hmm. But for one of them it's from one sale and the other one it's from 10 sales. Oh.

Speaker 2: Okay. Yeah.

Speaker: And so that's just kind of interesting. That's the idea. So by looking at the, that's what that ratio gets you.

Yeah. It kind of helps, you know, like, oh, is this actually a big one or is this a small one? Mm-hmm. And yeah, and obviously not, obviously typically bigger is better. It's very rare that that's not the case. Sure. But it's a general rule. Bigger is better. The next one is the net operating margin percentage.

Okay, so your net operating margin is essentially your your earnings before income and taxes.

Speaker 2: Mm-hmm.

Speaker: And you're dividing that by sales.

Speaker 2: Okay.

Speaker: So it's kind of like, so you start off with your gross margin, which is just, hey, your direct expenses, sales, minus direct expenses, divide that by sales. Now you're subtracting out a whole bunch of other stuff.

Your fixed costs and things related to that divided by sales, that is actually a ratio that I look a lot at.

Speaker 3: Mm-hmm.

Speaker: In, in for real estate. My hope and expectation is that well if I'm looking at just the net operating income, gross margin percentage, whatever, I want that to be like 60% Okay. Of revenue.

Speaker 2: Can you give me, like, give me like a real number example. So if we're making a thousand

Speaker: dollars a month in rent, I want to have my expenses be no more than 40%. Okay. Or $400. So therefore I want my net operating margin percentage to be 60%. Yeah. And then you subtract out debt afterwards. Okay. And ideally that number is at least 25%

Speaker 2: of the.

60,

Speaker: Of the thousand. Yeah. Okay. So yeah, so if I am, if I am making a thousand dollars after I've paid all the bank loans and stuff mm-hmm. I want like 250, 20 5%. Okay. Yeah. Ideally in a perfect world, by the way, so do banks. Oh. So that's one of the reasons why that's a pretty standard, that's a good number to know.

Yeah. Alright. Now these next three, I actually had to look them up. I didn't know what they were. They're all related. So you don't use them necessarily? No. And you'll see wine in a little bit. There's operating leverage, financial leverage, and then total leverage.

Speaker 3: Leverage,

Speaker: yeah. So leverage in general is talking about debt.

Speaker 3: Mm-hmm. Okay.

Speaker: And it's like a lever. How much is it? And leverage is really, it's an interesting concept because in general. Assuming the interest you're paying on the debt is less than the return that you're getting for it, the more leverage you have, the, the more it can increase your growth. Mm-hmm. But it's a double-edged sword if sales go down a little bit.

Right. It could go down a lot. So I had to, I, I wrote special notes so I can get all of these. So operating leverage measures how sensitive your operating income is. It's like your net income number mm-hmm. Is the changes in. Sales or revenue. So think of it in terms of if a tenant leaves, how big of a change is it?

And that could be to do the presence of fixed or variable operating costs. Okay. So like I think about like, I've got a property or warehouses. It makes a lot of money. Mm-hmm. And there's only three tenants. Oh

Speaker 2: yeah. Okay.

Speaker: And, and so in some ways it's very it has a, a high Yeah. Operating leverage.

Right. Probably how to say it, which is great on the upside, 'cause I make a lot of money from it. But if someone leaves. Yeah. Potential trouble. Yeah. I don't think I'm actually technically using that ratio correctly. Interesting. I think it's more about paying attention to the leverage side of it. Like how much debt do you have on the property?

Mm-hmm. Which is kind of a similar thing. Again, if you've got a really low debt percentage, the more you bring on, the more you're like, oh yeah, this is great. It increased, it gives my returns 'cause my return. 'cause I had to put in a lot less money. Mm-hmm. But now I'm really dependent on the, you know, on making sure those sales.

A change in sales. 'cause I have a high fixed cost could be a big difference. Here's another way to say it. Let's say that I've got a fixed cost of a hundred dollars pretty much no matter what. Mm-hmm. And so the good thing would be like one extra sale is almost pure margin. And so it very much can goose up your percentages.

Mm-hmm. But if your sales drop below, like say your mortgage amount. Now we have a problem. Yeah. And so it's kinda like interesting looking at that. The next one which I guess is technically number four on the list, is the financial leverage. These are all highly related measures, how sensitive your net income is to changes in your operating income because of the use of debt.

So again, it's saying if your debt, which I think that's what I was just talking about now that I said it out loud. So if your debt's kind of fixed, now the question is, well, if I can change my operating income mm-hmm. A bunch, like maybe I improve something in my expenses. Mm-hmm. You go, cool, that's gonna, that's gonna goose my returns a lot.

Speaker 3: Yeah.

Speaker: That has to be pretty standard across all real estate, which is one of the reasons why we don't like look at it too much. Mm. Whereas the operating leverage is more focused on, I think if I'm understanding this correctly, the operating leverage is more on your sales. Okay. Your revenue, your rent, how much can I increase rents by.

Mm-hmm. Whereas the, the other one, debt financial leverage is the debt is more on the, the debt Yeah. Side of it. Yeah. Like, how much debt can I get before this becomes a problem? Sure. I think total.

Speaker 2: I believe it.

Speaker: I know, I tell you, I have no idea. I tell you the formulas, but Well, okay. No, I took notes here.

Yeah. So on the operating leverage essentially, high. A high operating leverage means greater profit swings from small changes in sales. So the risk is that a downturn could hurt disproportionately, but the upside is like your growth really magnifies your profits. Financial leverage it magnifies your return to equity when your revenue is strong.

So essentially saying, yeah, if you have a lot of debt. It makes your return on investment really strong. Mm-hmm. Which is, which is true. But the risk is that you have an obligation that remains in a downturn. Mm-hmm. Increasing your default risk. Yeah. Yeah, yeah. That sense. That makes sense. And then total leverage combines the two.

So it's showing the sensitivity of your net income to changes in sales. 'cause it, and I'm not gonna go over the formula. Sure. You can look it up online chat will help you figure it out. So we'll Google. But this essentially, it captures the total risk exposure from both a cost structure and financing, financing decisions.

Speaker 3: Hmm.

Speaker: And so I was trying to, like, I was trying to think through, I, it's very similar. It's the, the debt service coverage ratio, I think is like the real estate. Equivalent of that one. Hmm. Which is saying, Hey, if you have your net operating income, divide that by your debt payment. Like, where's that ratio at?

How close are you to being,

Speaker 2: is that a, is that a cap rate?

Speaker: No, that's something totally different. That's your, that's your loan payment? Yeah. Cap rate is the revenue you get divided by the value of the property.

Speaker 2: Oh, okay. All the way around. Yeah.

Speaker: Value. Yeah, yeah, yeah. No, that's right. Okay. Yeah, it's a little bit different.

Mm. Yeah. Essentially all three of those are just helping you decide, like, evaluate how sensitive is this revenue. Mm-hmm. To, to little changes. Yeah. And the big takeaway, which shouldn't be a surprise, is that the more debt you have, the more sensitive it becomes. Sure. Both on the upside and the downside, which I think we all intuitively know is true.

Yeah. But I don't know if we do the math on it. Right.

Speaker 2: To actually figure it out. We may not know the the exact numbers, but it's like, well of course if something changes and you still owe money, that's. You know, it's a worse position than if you didn't owe as much money. You know, something changed. Yeah.

And that was paid off and then you have some margin, so. Right.

Speaker: But there's that contrast of you'll probably make less money Sure. If you're less leveraged. Probably. Maybe.

Speaker 2: Maybe. Yeah.

Speaker: Yeah. Alright, the next one, classic debt to equity ratio. This is exactly what it sounds like. Obviously conservative ratios are lower risk, which is nice.

But sometimes a little bit of debt can help juice the returns, right? And so yeah, that's one. I actually don't know what banks look for in that, if they care at all. Again, it really is like the payment. Is what they care a lot about. Right. But yeah, you're just trying to see what that, what that ratio is.

Tech companies have a amazing debt to equity ratio. Like they have like almost no debt. And just a ridiculous amount of equity real estate. But you know, it actually might start out where you know, you get a loan that's. It's a 80% debt to equity. Mm-hmm. Right. And then it slowly goes down over the next 30 years.

Hmm. So again, that's pretty normal in real estate. Yeah. But like, it's good to know what are you walking into? I think if you're starting to get above 80% you know that. Unless you're living in the house. Sure. That can get pretty risky. But I also think if, like, if a bank's only willing to give you like 60%, you might be like, what's wrong with this?

Hmm. That should follow. What do they know that I may not know? Yeah,

Speaker 2: they're they're hedging against Yeah. Risk that you're like yep,

Speaker: exactly. Which again, often it's influenced by the amount of revenue to the payment, not, not necessarily the amount of equity in the property. Okay. I thought this one was interesting.

Quick and current ratios. So in a balance sheet. You have like, you have like long-term assets, then you can have current assets. Mm-hmm. And quick is an another type of term of that. Okay. Like cash is a current asset. Mm-hmm. Land not so much. Okay. It's a long-term asset.

Speaker 2: Yeah.

Speaker: And so it's a measure of your liquidity.

It it how fast it can pay your short term obligations. Hmm. So oftentimes that's like when banks when they're first giving you a loan, they may say like, yeah, you know what? We'll give you an 80% debt to equity or loan to value, but we wanna see you have six months of reserves. They're trying to increase that current asset.

That makes sense. Not just in the property itself. 'cause they wanna make sure you have enough reserves to able to make payments just in case. Yeah. So so that's what, so current

Speaker 2: assets are like more liquid? Yeah. You can access them and use them if needed. Yeah.

Speaker: And I think this is actually a lot of mistake that a lot of newbie investors make is they get enough cash to do a down payment and then they go buy a property they use

Speaker 2: all

Speaker: and now their current assets is super low.

Yeah. That's the whole house. Rich cash poor Yeah. Problem. And then. If something happens, they wanna do something, and they're like, oh no, I don't under cash. Yeah. I'm like, yeah, that's, that's the problem. Mm-hmm. So so you wanna make sure you've got if it's me, like essentially like a three month reserve Yeah.

In there for emergencies is a good one. And you just, like, when you're talking to a syndicator you wanna see like, what are those reserves gonna be? And so so yeah, that's. That's that one. And then the final one, a classic, is return on equity. Mm-hmm. And so this is your profitability compared to he's talking about shareholder interest, but I'm like, yeah, you're on money.

Yeah. And what I think is interesting, and, and we've talked about this in past episodes, but, when you first buy a property, your return on equity and your return on investment are the exact same number. Mm-hmm. But over time, as a properties rents go up, your investment stays the same, and so that return on investment slowly ticks up over time.

It also doesn't take into account time, which is a problem. But your equity as you're paying down your mortgage slowly increases. So your return on equity number actually slowly goes down over time. And really that return on equity is measuring the opportunity cost. If you were to sell this thing and grab all that equity and do something else with it, what could you do?

Speaker 3: Mm-hmm.

Speaker: And so, you know, as a general rule you know, you think about the stock market, call it a, like a 8% average over time. Mm-hmm. If the return on equity starts to dip below 8%, you're like, okay, time to do something. You know, and so they have to sell it, but it might be time to. Refinance, unlock some of that equity and go off and do something else with it.

Interesting. To work in a higher investment Yeah. Situation. But yeah. That was actually the trigger why we ended up selling our duplexes. Mm-hmm. Because I was doing that math, our return on equity was ridiculous, like 52%.

Speaker 3: Yeah.

Speaker: But the value of the property itself and grown so much that the return on equity had dropped it to like a 3% return.

Mm. I was like, ah, okay. We gotta unlock the equity. And so that was why we actually sold the place and bought the warehouses. Instead and now those are slowly growing their return on equity. Interesting. Yeah. And eventually I will,

Speaker 2: you'll sell those Andy finger and put something different,

Speaker: something else on it, which is totally fine.

Speaker 2: Mm-hmm.

Speaker: Yeah, so I think one of the things you wanna remember is just don't focus on the story. Don't focus on the big narrative that, or the sales job that someone's doing, but really, like, and don't just do the, like what are the, you know, what are those big numbers? Mm-hmm. But really focus on those ratios.

Mm-hmm. I know your absolute favorite one. When we're looking at a single family home

Speaker 2: is cashflow.

Speaker: Nope. Your ratio, your favorite ratio?

Speaker 2: Oh, I don't know.

Speaker: You know your 1% rule

Speaker 2: Oh, is like, yeah, so it's the rent. Is the rent 1% of the asking price. Right? Yeah. Or more. More would be great.

Speaker: That's, that is a type of ratio.

Sure. But what that is for you is that's a shorthand to know that the cash flow will probably be positive Yes. After it hits a 1% ratio. Yeah. It's just a

Speaker 2: quick way of looking at it. If it hits the 1% Yeah. It's, it's likely to cash flow positive. Yeah. Yeah, yeah. Yeah. And

Speaker: I think one of the things we've gotten better about over time is not just looking at the cash flow number mm-hmm.

But. Paying attention to more ratios. Like, okay, yes, we can get this cash flow, but for what investment?

Speaker 2: Yeah.

Speaker: You know, like if I gotta invest a hundred thousand dollars to get a hundred bucks a month, it's positive. Yeah. But like, not really. Mm-hmm. Yeah. And so

Speaker 2: because of that opportunity cost. Yeah.

Speaker: Yeah, yeah.

So. Before you invest, especially in a company, but even in real estate, I think it's good to either you or have a sponsor look at those different ratios mm-hmm. And do some comparisons. Again, especially against other projects, I think is where you start to, to get more insight. Yeah. And, and then when you are talking to a sponsor you can ask 'em like, Hey, what's your plan to improve these ratios over time?

And, and hopefully they are saying stuff like, oh yeah, we're gonna build up a reserve fund, or we're gonna pay down the debt. Mm-hmm. Or we are gonna increase the rents. You know, like answers are all the same, but it's a way of having a conversation just a little bit more than surface level. Sure.

Speaker 2: I would say too, like if you're a normal person like me and they, they give you some answer and they're explaining the ratio to you and you're still like.

I did not get that. Yeah, like, like I asked at the beginning, can you be like a real life example? Like put some real numbers in there. I think that's totally appropriate to do with a sponsor. Oh yeah, totally. You know, to be like, okay, I think I understand, but can you, can you apply it like with some actual numbers so that I can fully wrap my head around it?

Yeah. You know that that's sometimes easier for me.

Speaker: Though I have learned almost like 99% of the time when I'm talking to people, they care a little bit about the numbers, but they just care more about the person. Like that's that's true. That's almost a hundred percent. I've even had people where they're like, yeah, I'm interested in investing.

I don't know what those numbers mean, but I'm in like, okay, I'm not gonna complain. Yeah. But okay. That's weird. Yeah. For me it's weird. But but yeah, so knows those are those eight ratios. Little bit of math. Hopefully it's okay. It's okay. But it's all right. The, the point being. Learn some of those ratios, learn which ones are important to you mm-hmm.

And calculate 'em and do 'em for multiple deals so that you can compare against a bunch of them. Mm-hmm. And it just helps to have conversations and learn the drivers behind the ratios. It's not just numbers themselves, but like, oh, what's causing this? How they actually work, go up or down. Mm-hmm. Yeah, so cool.

There you go. And I'm gonna tease this one next week. We're gonna talk about an actual deal that I bought recently, and we're gonna talk about all the ratios and numbers. Cool. So you'll see an actual live example of it. So if you liked this or even hated it, don't worry about it. The next one, we'll be much more entertaining and more hands-on on how this stuff applies.

Speaker 2: Perfect.

Speaker: So with that, thanks for listening. Absolutely. Appreciate it. Have a great day.