financial ratios 101, understanding financial ratio analysis basics, and best practices
Financial. Ratio, analysis. First, there's a four-step, process it, starts with return on equity and the, DuPont framework, with, the DuPont framework, we look at that return on equity and decompose, it into the profitability. Efficiency. And the, leverage dimensions, because we know that all three of those affect, a company's, return on equity to then find out a little bit more detail, about profitability. Efficiency. And leverage we can use the common, size financial, statements the common size financial, statements are the single most efficient. Tool at, getting insights, into a business look at that common size balance sheet, the common size income statement, from there we've identified efficiency. Or leverage, or profitability, problems, we need to drill down with some specific, ratios, with. Profitability, ratios, efficiency, ratios leverage, ratios, and finally. All of this is to prepare us for step four we need to talk with some people those are the four steps in the, financial, ratio analysis process. Now remember that the raw material, here the. Material, the data on which all this is based are the financial statements the balance sheet a listing. Of a company's resources, and obligations. Assets, equal, liabilities plus, equity if you've got assets you had to get the money to buy them from somewhere that's the balance sheet the, income statement, revenues. Minus expenses equal. Net income revenues, of the amount of assets generated, through doing business expenses, the amount of assets consumed in doing business in a, good business it's generating. More assets than its consuming, meaning it has positive net income and finally. The statement of cash flows operating. Activities, the things that a business does every day investing. Activities, investing. In the productive capacity, of the business by buying machines, and equipment, and buildings, and finally, financing, activities, getting, the money to buy the assets, borrowing, money getting. Money from shareholders the, financial, statements, are the, raw material. For a financial, ratio, analysis, why. Do, we do financial, ratio analysis, first if you're in a company if you're running a company you, do financial, ratio analysis so that you can fix problems, do, we have a profitability, problem, do we have an efficiency problem do we have a leverage problem you can't fix problems, until you have identified, them and financial. Ratio analysis. Allows you to, use financial, ratios use, common. Size financial, statements use the DuPont framework to identify where your problems are once, you've identified where, they are now you can start to fix them if you're outside a company, you do financial, ratio analysis to make decisions, like should I make a loan to a company should I invest, in a company as an owner why. Is this, company's, profitability, different, than the industry benchmark, lots, of why questions, and really, that's a key insight, with, financial, ratio analysis, the, numbers, lead you to ask more questions about, why so please realize that, yes it's, true that you cannot pick stocks using, financial ratio analysis but, you can identify good, companies, bad, companies, healthy, companies companies, with problems, using, financial ratio, analysis it's those private, companies those, small and mid-sized companies the companies that you might be asked to work for to, invest in to loan money to to, manage the. Whole point of financial, ratio analysis, is, to show you where, the issues are the, numbers, put. You right here, the numbers put you in the right room with. The right people asking. The right questions, you are an informed. Person, as you go into that room because you've done your financial, analysis, in the end of course you're, going to need to use your business judgment to make the decision, but you've got the, big picture with your financial ratio, analysis, you're right there with the people at the decision, table armed. With your financial ratio analysis, you're, ready. Step1, in a financial, analysis, is computing, return on equity and then, the DuPont framework, analysis, to look at the profitability. Efficiency. And leverage, components. We're now going to hone in on the leverage, component, of return on equity, with some specific, ratios first we'll look at current ratio which, is one of the top five ratios, of all time, then the debt ratio debt. To equity ratio and then the times interest, earned ratio. Let's start with current ratio, current. Ratio is a measure of liquidity liquidity. Reflects. The ability of a company to pay its obligations, in the short term short term we typically define as less than one year current. Ratio is computed, as current, assets divided, by current liabilities and.
Let Me remind you what, a current, asset is and what a current liability is, a current. Asset is an asset expected, to be used or turned, into cash within one year so, for example accounts, receivable that's a current asset because, we expect those accounts, to be collected, in cash within one year inventory. Is a current, asset because, we expect that image going to be sold and then the cash collected, all within, one year land, is not a current, asset typically, because if we come back a year from now we expect that land to still be their current. Asset a cash is also a great current asset because already is cash, so. Our current assets are the liquid assets, the ones that we expect to become cash, soon. In less than one year. Similarly. Current, liabilities. Are the liabilities, that we expect to have to pay within one year accounts payable is a good example of a current liability we're, going to pay our suppliers what, we owe them within, one year, so, the current ratio reflects, the, balance between the, assets, that we have that are going to become cash within one year and the, liabilities. That we have that we're going to have to pay within one year and we like to see a bit of a cushion there so. The current ratio for, nordstrom is 2.1. In, 2013. For, Dillard's is also over, 2 the, general rule of thumb for. Current ratios is that they're typically greater than two banks. Like to see current ratios. Typically, greater than two in fact, it's very common. In bank, loan, contracts. That a bank will, say to a borrower your, current ratio has to stay above a certain level above, 1.5. Or above 2 and if you fall below 2 we, start to get nervous maybe you're not going to be able to pay us when you are supposed to pay us and so, your loan is in default so. The rule of thumb is current, ratios should be greater than 2 but that's an old rule, of thumb in the new world that we have now the, technology, world companies. Are able to manage their current assets much more efficiently, companies, don't need as much inventory, as they used to need because, their information, systems can track, their inventory, very carefully, and so companies don't need to have as much extra, inventory, lying, around cash. Can be managed more tightly accounts. Receivable can be tracked more precisely, so. In recent years current, ratios have slipped, below 2 in, fact you see a list, of very safe. Financially. Safe companies, here all with, current ratios less than 2 that's, normal, these days so, the old rule, of thumb the rule that your mom and dad learned when they went to school was current ratio should be about 2 all, current ratios are often less than 2 now but. In general remember that the current ratio reflects, liquidity. The, ability, of a company to pay, its debts in the short term and we like to see that steady, if that starts to slip in any given company we, get nervous about that company's, ability to pay its debts in the short term. And. The DuPont framework we're looking at the three components of, return, on equity profitability. Efficiency. And leverage, let's, look at leverage investors. Putting, their investment, in the company but if that investment, is not enough to buy all the assets they need to, fulfill their business objectives, they, need to borrow money they, need to leverage their investment, that makes the business larger.
With The same initial, shareholder. Investment, that's, reflecting, the assets, to equity, ratio a measure of leverage, why, does a business want more assets because more assets, generate, more sales that's. Reflected, in the efficiency, measure why, does a business want more sales more sales, means more net income that's reflected, in profitability, with, more leverage, a company's. Return on equity can be higher even, with the same amount of shareholder. Investment, so let's look at some specific measures. Of leverage. Measures. That are commonly, used debt. Ratio very simple measure total liabilities, divided, by total assets, the, rule of thumb is that for large companies, a debt ratio is usually between 50 and 60 percent so. When I see that 50 percent debt, ratio for Dillard's I think fine they're normal they've leveraged, they've borrowed about the same amount as most companies borrow, when. I see that debt ratio, of Nordstrom. On the other hand of 75, percent I now have some questions, I'd like this chief, financial officer, the CFO, for, Nordstrom, to come here and tell me what was the business decision, that you made so that you have so much leverage, why. Do you have 75, percent leverage when most of your competitors have substantially, lower leverage, what's the decision there that's debt ratio total, liabilities, divided, by total assets, the fraction, of financing, that was obtained through borrowing. Another. Measure of leverage is called the debt to equity ratio. Total. Liabilities, divided by total shareholder. Investment, we've got a simple company investors, invest $1 they, then go out and borrow $1 and with, those $2 can now buy 2 dollars of assets 2. Dollars of assets coming. From $1 of borrowing liability. And $1, of owner investment, let's, now compute, three different, measures of, using, the same common, set of data the, debt ratio, $1, of liabilities, divided by two dollars of assets 50%. Half, of the financing, has come through borrowing the. Debt to equity ratio, total. Liabilities, divided by total equity, is one it's one to one we have exactly, as much borrowing as we do shareholder, investment, the, assets, to equity ratio is two total. Assets is two, shareholder. Investment, is one we have twice as many assets, as we could, buy with our own invested, money that means we had to leverage, our investment, you see that there are three different measures of the same underlying, leverage.
Why. Do we have three well. It's just a matter of taste people, use different ratios they all reflect the same thing so, how do we know which one to use well. The way you know is ask the, person on the other side of the table which leverage, ratio are you using for example. Somebody. Tells you that the temperature is, 22. Degrees so. Hot or cold it. Depends, on what measure you're using are you using the Fahrenheit scale then. 22, degrees means it's cold below freezing you better have a code on are you, using the Celsius scale 22. Degrees it's comfortable, room temperature, are you, using the Kelvin, scale well, then it's almost, as cold in fact a little colder, than it is on Pluto. The. Same number 22, means a different thing depending, on what scale you're using same. Thing with these leverage, ratios, let's say that somebody tells you to the leverage ratio is 0.5, what. Does that mean well, are they talking about the debt ratio they're, talking about the debt ratio a debt ratio of 0.5, means that half of the total financing, has been borrowed, 50. Percent of total financing, is borrowed. Total, liabilities, divided by total assets. Or, are, they referring to the debt to equity ratio that's. 0.5, well, then that means that the borrowing is half as much as the shareholder, investment, that works out to be this one-third. Of the, financing, has come from borrowing, and two thirds twice as much has come from shareholder, investment, what. Does it mean if the assets, to equity ratio is 0.5, it means, shareholders, have invested, money the, managers, of the company have ruined half of those assets, and now the assets, are only half, as much as what the shareholders, originally put in so, you can see that a leverage ratio of 0.5, what does that mean it depends on the scale so. When you're talking with somebody and they say the leverage ratio is 0.5 you need to stop them right there and say wait are, you talking about debt, ratio debt, to equity ratio or assets, to equity ratio are you talking about Fahrenheit, Celsius, or, Kelvin you, cannot interpret the number until you know what ratio is being used now. One common feature of all, these measures of leverage is that they all come, from balance, sheet numbers assets. Liabilities. Owner, investment, there's, also a very important, income, statement focused measure of leverage and this is called times interest, earned these.
Numbers Come from the income statement its, operating, income divided. By the amount of interest expense, that's. The benefit of leverage there are also risks, associated, with leverage once. You borrow money you now have the relentless, fixed, cost of that interest and whether, things are going well or going poorly, you still have to pay that interest what, that means is if your, business experiences, a short-term, downturn. You. May not live through that short-term downturn. Because you have to pay your interest you, could go, into bankruptcy because you can no longer pay your interest and are. Those borrowed, resources. Being used efficiently to generate, enough, profit, to be able to pay the interest on the borrowed money if not so you're digging yourself deeper and, deeper, into a financial, hole there, are benefits to leverage there, are risks to leverage prudent. Leverage, in a business can increase the return on equity but, leverage has to be used prudently. You. Since, we're gonna be using the financial, statements to do our analysis, let's review the primary, financial statements there are three the, balance sheet the income statement, and the statement of, cash flows let's briefly review what is contained in each one of these three primary financial, statements and we'll start with a mother of all financial statements the balance, sheet the balance, sheet is a listing of a company's assets its. Resources, its valuable, things its cash its, land, its inventory, the things, that it holds to sell those, are its assets, and the, other part of the balance sheet is a listing of where the company got the money to buy those assets, the liabilities, and the equities the, balance sheet embodies, the accounting, equation one, of the greatest inventions. Of the human mind invented, in Italy over 500, years ago a listing. Of the assets, which is easy anybody can list assets, but, the insight is to then also list where do we get the money to buy those assets, the liabilities, and the equities that's the balance sheet now assets. They're valuable, resources. Cash. For example accounts. Receivable, money. That is owed by, other, people, to a company that's an asset, land, buildings. Equipment all of these are resources, that a company uses in, accomplishing, its objectives, those are the assets we're. Gonna use a hypothetical, example to, do some financial ratio, analysis so. Let's make up this example now it's we'll call the company very cleverly uncertain. Company, we're not sure how sure how uncertain, company, is doing so. Here are the assets, for this hypothetical uncertain. Company, cash. 700. Accounts. Receivable, money owed by other people to this company on certain company of 4,000, inventory. The things that uncertain, company holds to sell to other people and finally property, plant and equipment land, machines. Buildings. Of 8,000. Total, assets. 14,500. And let me see if you remember what I just said about the accounting, equation if a, company has assets, of, 14,500. Then that same company also has to have sources, of financing, to buy those assets, what. Are those sources, well, possible, sources are liabilities. Liabilities. Are obligations. To repay, money or to, provide a service, in the future so, Walmart for example where does Walmart gets most of its inventory, the things that Walmart, on its shelves, to sell to you and me suppliers. Finance, it suppliers, saying you can pay us later we call those accounts payable other liabilities Disney, has borrowed money on a long-term basis.
United, Airlines has a very interesting liability. When, you and I fly on United, Airlines we pay first and fly, later in the interim United. Airlines owes us a ride on an airplane that's an obligation that's, a liability that's, listed on United, Airlines balance, sheet the liabilities, for, our hypothetical uncertain. Company are to accounts. Payable two thousand five hundred and long-term. Debt four thousand, five hundred total, liabilities seven thousand meaning of those fourteen thousand five hundred dollars in assets that uncertain company has seven. Thousand, of those dollars came from borrowing, in these two different forms the second source of financing to buy assets is owner's, equity money. Provided. To the company by the owners, and owners can do this in two general ways one, is that the owners can take money out of their personal savings and put, it in the company they were working for years saving, a thousand dollars here $1,000. There now they put it in the company we call that paid in capital that's one way that owners invest, in their company a second. Way that owners, invest in a company is by keeping profits. Of the company in the business we call this retained earnings the profits of a business, belong. To the owners the, owners can take those profits out and use them to buy groceries, or to buy a boat or whatever else they want to do or the, owners can say let's put those profits back in the business we call that retained, earnings, paid, in capital and retained, earnings are the. Amount of money that are provided, to the company by the owners, to, then buy assets, the, equity, of uncertain, company is paid, in capital of 1500. And retained, earnings of 6,000, so let's see if this adds up the assets, of uncertain company. 14,500. Where'd, an uncertain, company get the money to buy those assets. $7,000. Was borrowed, and, 7,500. Was invested, either directly, or indirectly, by the owners it's, perfect, the accounting equation always. Works, assets. Equals liabilities plus, equity if you've got assets you had to get the money somewhere to buy those assets, and that's true for Citibank, for, Walmart for Apple, or for that corner drugstore you've got assets, you gotta get the money to buy those assets from somewhere and those relationships, which, assets, in what mix and where did we get the money to buy those assets those tell, very, important, things about a business its strengths, its weaknesses and, its risks we're going to use the balance sheet in financial.
Ratio Analysis the balance, sheet the mother of all financial, statements. You. The, second primary financial statement, is the income, statement, revenues. Minus, expenses equals. Net income we, use the terms revenues, and expenses, all the time so let's make sure we know what these words mean in an accounting, context. Revenue, means the amount of assets, generated, in doing business and different. Companies generate assets in different ways Walmart. For example generates. Assets, by putting things on shelves that, you and I buy Walmart's. Inventory, we pay Walmart, for those things that's how Walmart, creates, assets. Microsoft. Creates assets, by creating, software, and hardware that you and I then buy and we pay Microsoft. For those things Disney. Has, consumer, products, they have cruises, they have theme parks we pay to use, those things or to buy those products, and that's, how Disney generates, assets revenue. Is the amount of assets, generated. In doing business. Hopefully. The. Assets generated, are less than the assets consumed, expenses. Are the amount of assets consumed, in doing business for, example Microsoft consumes. Assets by paying programmers, by paying for equipment Walmart. Consumes assets by buying the inventory that sells to you and me and paying, rent by seeing its buildings to depreciate, by paying its employees. McDonald's. Consumes, resources by buying food buying paper by renting facilities, in each, case the, revenues, hopefully, are more than the expenses, that, are consumed, in generating. Business all. Of this is put together in the income statement net, income revenues. Minus expenses equal, net income net, income, is a very sophisticated, economic. Measure it's the net amount of assets, generated, by a business, through, its business operations, this, is the income statement, to do our ratio analysis let's use the income statement for a hypothetical, company uncertain, company sales, that's.
Their Revenues minus. Their expenses, cost of goods sold wage. Expense research. And development expense and advertising, expense leaving net income of $700. We're going to use this income, statement for uncertain, company to understand, is this company earning lots of money or a little money and if it's not very much why not which expenses, are causing problems the, income statement the second of the primary, financial, statements. You. You. Third, primary, financial statement, is the statement of cash flows, conceptually. A statement cash flows is quite simple cash, in cash out the, inside of accountants, is to separate those cash flows into three categories, operating. Activities, investing activities. And, financing activities. Those. Three, categories, of cash flows are what are reported, in the statement of cash flows operating. Activities, are what companies, do every, single day collect. Cash from customers, pay cash to buy inventory pay, cash to employees, pay, cash for rent for. Advertising. For research, and development all those things are operating activities think, of operating activities as the things that a business does every, single day and hopefully a company. Would generate, cash from its operating activities you would hope that a business would be collecting. More cash than its spending on a daily, basis, the. Second category in, the statement of cash flows is investing. Activities, this. Investing, means investing, in the productive capacity of, the business buying. Machines, buying, land buying, buildings, those. Are investing, activities, in contrast. To operating, activities which happen every single day investing. Activities, happen occasionally. You don't buy land and buildings every single day you do that on occasion operating. Activities things, that our business does every day investing. Activities, investing. In the productive capacity of business happens. Occasionally the. Third category in, the statement of cash flows is financing. Activities, and this is exactly what it sounds like it's, financing, borrowing. Money repaying. Those loans getting, cash from investors, paying, dividends, to investors, getting, the capital or financing. To buy the assets, that a business needs a way, to think of the statement of cash flows as financing, activities, I'm getting, the financing in the capital, to buy the assets the.
Investing Activities to then conduct the operations, the operating activities these, are the things that a business does the, statement of cash flows is built around operating. Investing. And financing activities. Now. I have some bad news about, the, statement of cash flows you're going to have to say goodbye to the statement of cash flows at this point because most. Financial. Ratio analysis, is done without, cash, flow ratios, the, reason for this is that the cash flow statement is so new it's less than 30 years old in contrast, the, balance sheet and income statement are over 500, years old so the standard, financial, statement. And ratio, analysis, formulas. Don't really include, financial, ratios, related to cash flow the, balance sheet the income, statement the statement of cash flows those are the three primary financial, statements in our ratio analysis, we'll focus on the first two the, balance sheet and the income statement. Now. Let's look at some specific profitability. Ratios, and we'll start right at the top of the income statement with gross profit, percentage, gross. Profit, is sales, minus, cost of goods sold if Nordstrom's. Sells you something, for $100, and they. Pay $65. To buy that thing from their supplier then Nordstrom's. Gross profit is $35. And their gross profit, percentage is 35%, the. Fraction, of the selling price that Nordstrom, gets to keep right off the top and in. A retail organization. Or in a manufacturing organization. Or an organization that, sells a service you would hope that this gross profit, percentage stays stable, now, the, gross profit percentage, is very important, because if you start to have problems they're, the, only way to make up for that further, down in the income statement is by belt-tightening. Pay, our employees less pay less for electricity, pay less for rent it's tough if the, gross profit percentage, starts to suffer it's hard to maintain profits. By, tightening, up on your overhead expenses, let's. Go down the income statement one more step and look at operating, profit, percentage, operating. Profit is the profit, made by a company by doing what it normally does from its operations. It's gross, profit, minus, those, overhead, expenses, the selling general and administrative expenses, and, in a business we want to see operating, profit percentage be stable, now there's a ratio that is related, to operating, profit, and it's called EBIT da so let's go step by step here, we'll start with the little brother of eBay da EBIT, EBIT, the acronym, stands for earnings before. Interest, and. Taxes, it's a synonym for operating, income but, even sounds much more sophisticated, EBIT. DA the, DA part stands for depreciation, and amortization these. Are legitimate business, expenses, the wearing out of our machines and our buildings, and other assets, but they don't involve cash this year so. EBIT, da can be viewed as an approximation, of our operating, cash, flow, and is a very, common, measure EBIT, da if you're hanging around business people and you say 'hey but you'll. Feel immediately, like one of the club so a very important, ratio, is e but, none of by sales and again we see that here for Nordstrom's and remember what, this reflects is an approximation. Of. Operating. Profitability. From, a cash standpoint. And we would expect our operating profitability, always, to remain stable now Amit does a very, well-known, number and I'll just give you when. Appraisers. Are appraising small businesses, a simple, rule of thumb is this a small business is worth that businesses, EBIT, da x. 5 now, I'm not giving you appraisal, advice here but EBIT dies such a commonly, used number, that it's used in appraisals, and other things so make sure you remember eBay da earnings. Before interest. Taxes. Depreciation and. Amortization. Let's. Talk about another class. Of financial, ratios, ratios. That involve comparing a financial, statement number, with a market, value number and, the. Primary, ratio in this category is the p/e ratio, the price to earnings ratio. This is one of the most famous ratios, of all time it's a connection between the. Amount, of net, income that a company is generating this year its earnings, and the, price or the market, value that people are willing to pay for that company and as, you would think if a company has higher growth, prospects, in the future the.
Price Earnings ratio is going to be higher because of this reason when. You buy a company are, you buying its past or, you. Buying its future you're buying the future and if the future looks very large compared, to the earnings right now you're going to have to pay a premium, to buy that company so higher, price, earnings, ratio reflects, market, expectations. That earnings, or net income in the future will be much higher than they are now most. PE ratios, are, between 10, and 30, almost all companies have p/e ratios between 10 and 30 which means this if the, company has income, of this. Year of $1. And the, p/e ratio is 10 to buy. That company I have to pay 10 dollars, now, sometimes, PE ratios, can get crazy back, around the year 2000. That p/e, ratio sometimes were in excess, of 2000. Meaning, if you had earnings of $1.00 people, would pay $2,000, to buy that company it. Was crazy but what it reflected, was people's. Expectations. That earnings at that time were small, compared, to what earnings were going to be in the future large, expected, future growth so, the p/e ratio, reflects how fast. Market. Investors, think that a company's earnings will grow in the future profitability. Ratios, in general are our way, to, drill down and figure out why, companies having profitability, problems, or profitability, successes. There. Are specific profitability, ratios, that we can look at the gross profit percentage, what, profit are we making right off the top as we sell our products, the, operating, profit percentage, what's, the profit from the things that we do on a daily basis, EBIT da divided, by sales reflects. A cash. Offering performance, measure return, on sales, that's everything put together and we want to look at the different components, using, the common size income statement, and finally, the price earnings ratio. Shows that connection, between. Market, values of companies, and their, current net income or earnings. Remember. Profitability. Is just one dimension. Of the, DuPont framework, profitability. Efficiency, and leverage, it's the dimension on which we usually focus, most of our attention and, it's a very important, dimension but remember that it's only one. Okay. We just finished looking at the profitability ratios, now, let's look at the efficiency, ratios, we. Have three specific. Efficiency. Ratios we're going to drill down on first. One is number of days sales in inventory, the second is average collection period and the, third is the fixed asset turnover what, are those well. The number of days sales and inventory tells, me how, long on average, does, my inventory stay. With me until it's sold the. Average collection period tells, me on average. How long from, when I sell, something on credit, till. I collect the cash, those. Two together stays. Sales in inventory and average collection period. Indicate. What we call the company's, operating, cycle, then. The third efficiency. Ratio we're going to look at is our fixed asset turnover that is how, many dollars, worth of sales do our fixed assets, generate, so, let's. Look first at the inventory, turnover we. Buy inventory, and the question is how, long until we sell that inventory, can. We calculate on, average, how long our inventory, sits in our store for example well. We have a measure for that it's called, days. Sales in inventory, and the, first step in calculating day sales and inventory is we take a measure. Called our inventory, turnover that is how often do we turn our inventory. Over, every. Year think, of it this way I have, inventory how. Long until I sell it all buy. More sell. It all buy. More sell, it all how many times do I do that in a year there's, an easy way to calculate that and that is to take our cost of goods sold and, divide. That by our average inventory. For the year now why, use average inventory, for the year well, cost of goods sold occurs, throughout. The year and. Our. Inventory, comes and goes throughout the year as well so tamasha. Cost. Of goods sold throughout, the year measure. We. Approximate. How much inventory do, we have on average, throughout the year we'll take our beginning inventory balance at our. Ending inventory balance. Divided by two to, get an approximation, of how much inventory did we have on average, throughout the year, so, to calculate inventory, turnover cost, of goods sold divided by average inventory. You. OK, we've calculated how long our inventory, is with us by calculating, days sales in inventory we, can do the same thing with receivables, if we sell that inventory on credit, how, long until we can expect to get the cash, we may have terms of net 30 but.
We Can calculate how close to that net 30 for example we. Are getting by calculating, an hour, average collection, period there. Are two steps in calculating, average collection period just. Like with inventory the first thing we do is calculate our accounts. Receivable turnover, we. Take our sales revenue, this time remember with the inventory we took cost of goods sold with. Accounts receivable, we're going to take our sales. Number, and we're going to divide that by average. Account receivable, and to, review why do we do average account receivable, remember, sales. Occur throughout the year we. Don't want to compare sales throughout the year with account. Receivable at the end or, accounts. Evil at the beginning. It, would be nice if we had an average account, receivable, balance as well and we calculate, that by just taking beginning, balance plus. Our ending balance dividing, by two and then dividing, that into our sales revenue, what, do we do with these numbers well as we did with inventory we'll simply divide them into 365. Two to, have a day's, measure. That we can compute our average, collection period it turns out if money, is tied up in receivables. That constrains. What you can do as a business just as when money is tied up in inventory it, constrains, what you can do as a business we need to keep an eye on how efficiently, we are managing our inventory, how, efficiently, armet we are managing our receivables, as well. You. There. Are potential, pitfalls, associated. With financial ratio analysis, and we've got to be aware of those, pitfalls so that we can carefully, do our analysis, and carefully. Apply our results, first, is financial, information. Is, not, all the, value relevant, information, that's available about, a firm, secondly. Financial. Statements, from different, companies are sometimes, not comparable, third. Common, mistake is we, always seem to be searching, for one, problem, when, it could be that there's a multitude, of reasons the company's doing very well or doing very poorly and then. The fourth common mistake with financial ratio analysis, is we weight information. Differently, we either look at history, too much the distant, past too much are we entering, the. Recent past we've got to be careful, when we're using information, to apply it appropriately, let's, take a look at the first one financial statements, don't contain all value, relevant, information, it turns out financial, statements are only one part of the, information spectrum. There's, lots, of information available, about, a company, out there and while. Financial. Information is, relevant, and reliable, it's not everything and, the danger is the precision, of the financial, statement numbers can, be very misleading we, may think it's more important than it is because there are numbers, attached to it so we got to be very careful when. Using financial, information to, not overweight. It in terms of it's important, for example for publicly traded companies, in the United States, company. Stock prices, fluctuate, every, day in response. To all sorts, of news economy-wide news industry. News company specific, news every. Day and yet. Financial, statements come out once, every three months for for, publicly traded companies, we've, got to make sure that we incorporate all, information. And not, overweight. The financial, information we've, got to be very careful sometimes, financial. Information with its precision, can. Lead us to assume, that it's more important, than it is financial, statements the second one financial. Statements from different companies are sometimes not comparable, they may classify items. Differently, they, may use different accounting. Methods or assumptions, or we may have a conglomeration, we, may have a business that's a conglomeration. Of a variety of business, segments, so, before, we do comparisons. Of two financial, statements to companies, we've, got to make sure that it's apples, and apples. We've, got to be very careful so, we've got to be careful, when, we're comparing one company, with another that, not only are, they in the same line of business but. They use the same accounting, methods and they classify. Items, on their financial statements the same we've, just got to be careful when doing comparisons.
Third. Potential, pitfall, is our tendency to search for a single, smoking, gun one reason, that, a company is doing well or one, reason, that a company is doing poorly we have this human tendency to want to solve a mystery by being able to point to one thing turns. Out in a business context, usually there's not one, single reason for poor or great performance, often it's. A series of small issues that, lead to a very big issue when, it comes to business, it's often a collection. Of events that determines, whether a company does well or a company does poorly a fourth. Pitfall, when, we anchor, on information, that may not be as relevant financial. Ratio analysis, uses the past to help us forecast. The future recent. Past is much more relevant than the distant, past so, we've identified four, potential, pitfalls, when it comes to using financial, ratio analysis, first we've got to remember the, financial, statements don't contain all the, value relevant, information, when it comes to a firm there's, information about the economy, about the industry, about the firm. Specific information, the. Financial, statements while important, aren't everything. We need to be careful that, we don't assume that the precision, of the numbers, means, they're more on that information is more important, often, it is not the. Second, we've, got to be careful when we use financial, statements and we're comparing companies, to make sure they're comparable, companies. May be in different industries we've, got to be careful it, could be that they. Use different accounting, methods we need to make sure that the methods, underlying, the numbers are consistent. So that when we compare we can reach a reasonable conclusion. The third our, tendency, to search for a smoking gun there's, got to be one reason this firm is doing well or one reason this firm is doing poorly often. Will find there are multiple, reasons all the little things that that. Add up to a big thing, it's seldom one, big thing and then the fourth potential, pitfall, we've. Got to be careful when using the past to predict the future turns. Out the more relevant, information is the recent past we don't want to go too far, back in predicting, the future because. That information may or may not be as relevant as just the last couple of years be, careful, when doing financial, ratio analysis, it's very powerful, when. Used appropriately. You.