Financial Ratio Analysis【Deric Business Class】
Hey guys. Welcome, to derek business class. In this video, i'm gonna show you how to conduct, financial, ratio. Analysis. Financial. Ratio, analysis. Involves, methods of calculating. And interpreting, financial, ratios. To analyze, and monitor the firm's, performance. Management, is concerned, with all aspects, of the firm's, financial, situation. And it attempts to produce, financial, ratios, that will be considered, favorable, by both owners, and creditors. Comparing, ratios. Is more objective, and relevant than simply comparing, different figures, from the financial, statements. Let's take an example. Company, a has made a net profit of one hundred thousand, dollars. Whilst, company b has made a net profit of ten thousand, dollars. So, company, a has made more profit, than company, b. Can we simply make a conclusion, by saying. Company, a is better than company, b. Of course not. One more thing we have to consider, is, the sales. Let's say. The sales of company, a is one million dollars. Whilst the sales of company b is 20 000. We may calculate, the profit margin, by taking net profit over sales. So, the profit, margin of company a is 10. Whilst the profit margin, of company b is 50. Now, you will see that company, b is better than company, a, because company, b, can make more profit based on lower sales. Which means company b is more efficient. There are two types of ratio, comparisons. First type is trend analysis. Or time series, analysis. Trend analysis. Is used to evaluate. A firm's performance, over time. This is to compare the performance. Of one company, over many years. Second type is cross-sectional. Analysis. It is used to compare, different firms at the same point in time. Which means it compares, many companies, over one year. Under cross-sectional. Analysis. You can either compare, one firm's, financial, performance, to the industry's, average, performance. Which is called the industry, comparative, analysis. Or compare, one firm's, financial, performance, to the performance. Of industry, leader or key competitor. Based on benchmarking. In the following, part. I'm going to cover five different categories. Of financial. Ratios. First. Liquidity, ratios. Which is to measure firm's ability, to meet its maturing, obligations. Second. Activity. Efficiency. Or asset management, ratios. Which is to measure how efficient a firm is in using resources. To generate, sales. Third. Debt, or financial, leverage, ratios. Which is to indicate a firm's, capacity. To meet short and long-term, obligation. Profitability. Ratios. Which is to measure the firm's ability to generate, profits, on sales. Assets. And stockholders. Investment. Fifth. Market, value, ratios. Which is to show the market's, perceptions. Of a firm's, performance, and risk. Let's look at the first category. Liquidity, ratio. It is used to determine, a debtor's ability, to pay off current debt obligations. Without raising, external, capital. To calculate, current ratio. We take current assets, over current liabilities. Another, similar, formula, is acid test ratio. In which inventories. Are removed from the formula. So, acid test ratio, equals to current assets, minus, inventories. Over current liabilities. Liquidity, is the ability, to convert, assets, into cash quickly and cheaply. If the current ratio, of a company is above industry, average. It shows that this company, is less risky than other companies, in the same industry. For current ratio. The higher the better. However. Sometimes. High current ratio, is not necessarily. Better liquidity. It could be due to high inventory, level, which causes, current assets, to increase. Indicating, a firm's, problem in inventory. Turnover. That's why we have the second, formula, for liquidity.
Which Is called acid test ratio. Also known as quick ratio. Which is more stringent, as illiquid, inventory, is excluded, from the current assets. Let's take an example. Let's say. There are three companies. Company, a, b, and c. Their current ratios. And quick ratios, are shown in the table. All three companies, have current ratios, of 1.3. However. The quick ratios, for company, b and company, c are dramatically, lower than their current ratios. But for company, a, the two ratios, are nearly the same. Why. The reason is because. Company, a doesn't keep much inventory. Compared, to the other two companies. Therefore. Company, a is more liquid. The second category. Is activity, ratios. They are also known as efficiency. Or asset management, ratios. Account, receivable, turnover, is calculated. By taking, credit sales over account receivable. In which account receivable, means the amount of money the customers, have not yet paid back. Account receivable, turnover, shows the number of accounts, receivable, a company collects, during a year. In other words. It shows how many times, customers, make payment to the company during a year. For account receivable, turnover. The higher the better. Another, alternative, is to convert the turnover, into period. Which means how many days. Average collection, period, is calculated, by taking account receivable. Over annual, sales over, 365. Days. Average collection, period, shows the average, number of days account receivable. Remains, outstanding. Or, it means how many days it takes for customers, to make payment. The shorter the better. The shorter average collection, period, means customers, take shorter days to pay back money. Higher account receivable. Ratio. Or shorter average collection, period, may imply. A company, operates, more on a cash basis. When customers, pay by cash. Account, receivable, will be reduced. So account receivable. Ratio, will become higher. A company, is efficient, in the collection, of account receivable. The company, has high proportion, of quality, customers. The company, has a conservative, policy, regarding, its extension, of credit. For example. Company, uses a shorter credit term. Customers, are required, to pay back in 30 days. Or even shorter. There is variation. In customer, composition. Such as. Different segment. Or different collection, policy. Next. We have account, payable turnover. It is calculated. By taking purchases, over account payable. In which account payable, means the amount of money that we have not paid back to the suppliers. Account payable, turnover, shows the number of accounts payable, a company, pays during a year. In other words. It shows how many times, we make payment to the suppliers, during a year. For account payable, turnover. The higher the better. Higher account, payable turnover, helps the company to build good credit with the suppliers. Another alternative. Is to convert the account payable, turnover, into average payment, period. Average payment period, is calculated. By taking account, payable over annual, purchases, over. 365. Days. Average, payment period, shows the average, number of days a company, takes to make payment to the suppliers. The shorter the better. Generally. Lenders and credit suppliers. Are more interested, in account payable turnover, ratio. This ratio, may affect the suppliers, decision, of giving how much credit sales, and how long credit terms to the company. Higher account payable turnover, ratio. Or shorter average payment period, may imply. The company is more efficient, in making payment to the suppliers. The company, is more efficient, in generating, cash. Next. We have inventory, turnover. It is calculated. By taking cost of goods sold over inventory. Inventory, turnover, shows how many times a company's, inventory, is sold, or replaced, over a period. Similar to other formulae, of turnover. Inventory, turnover. The higher the better. Higher inventory, turnover, shows that, the company, does not keep the inventory, for too long. Another alternative, is to convert, the inventory, turnover, to inventory, holding, period. It is calculated. By taking inventory, over cost of goods sold over, 365. Days. Inventory. Holding period, shows the average, number of days a company, takes to sell its inventory. The shorter the better. Keeping the stock for too long may cause the products, to become obsolete. People would not be interested, in outdated, products. For inventory, turnover, ratio. Usually. We apply average, inventory, figure. By taking beginning, inventory. Plus sending inventory. Divided, by two. To compute, inventory, turnover.
This Is to average out any seasonality. Effect, on the ratio. A low turnover. Or a long holding, period, is usually a bad sign, because, products, tend to deteriorate. Or become obsolete, as they sit in a warehouse. A high turnover. Or short holding period, may imply. The company, is selling perishable. Items. Such as groceries. The company, is running out of stock and losing, sales to rivals. Next. We have fixed assets, turnover. It is calculated. By taking sales, over net fixed assets. Fixed assets, turnover, shows how able a company is, to generate, sales, from fixed asset, investments. Namely, property. Plant. And equipment. A higher asset turnover, ratio, indicates, that, a company, has more effectively. Utilized. Investment, in fixed assets, to generate, revenue. Another, similar ratio, is total assets, turnover. It is calculated. By taking, sales over total assets. It shows how effective, a firm is to generate, sales from total asset, investments. These ratios, can vary widely, from one industry, to another. Companies, with low profit, margins, tend to have high asset turnover. While those with high profit, margins, tend to have low asset, turnover. For companies. There are some factors, in affecting, how much to invest, in fixed asset. These factors, include. Cost of asset required. And how long to be used. The depreciation. Policy. Straight-line. Method. Or accelerated. Method. For accelerated. Method. Net fixed asset value may decrease, more. Extent of assets, being leased or owned, which means how long can the company lease, or on the assets. Technology. Used. Firms in the same industry, may adopt different technology. Different assets, are needed for using different technology. A manufacturing. Company may invest, more in fixed assets. While an internet, company. Such as facebook. May be lesser. That is, internet, companies, tend to have higher fixed assets, turnover, ratios. Which is not comparable, to other industries. The third category. Is debt ratio. It is also known as leverage, ratio. Debt is long-term. Or short-term, liabilities. Debt ratio, measures the degree to which a firm is employing, financial, leverage. Firms with high debt offer less protection, to the creditors, in the event of bankruptcy. To calculate, debt ratio. We take total debt over total assets. For this ratio. We can't say higher or lower, is better. Higher debt ratio, means the company, is having higher financial, risk. Whilst lower debt ratios, means lower financial. Risk. Bond holders, and creditors, are interested, in this ratio. As this ratio, tells them how much risk they are facing. If they invest in this company. Low debt ratio, is preferable. As it provides, more protection, in the event of liquidation. Or any financial. Problem. High debt ratio, means high fixed interest, charges. Firms could be unable to make interest, payment in the event of economic, recession. Ordering, low seasons. Low seasons, happen when company, has low revenues. Debt to equity, ratio. Calculated. By taking total debt over common equity. It measures, the company's, debt relative, to the total value of its stock. A high debt equity, ratio, generally, means that, a company, has been aggressive, in financing, its growth with debt. For taking higher debt. Company can invest in more projects. So that, it will have higher earning potential. Eventually. It will be benefiting. Shareholders. However. If the cost of debt is higher than the return. Which means. What the company, pays is higher than what the company earns. So. Shareholders. Value would be badly, affected. Although taking debt can grow the company. Excessive, debt could lead to liquidation. And bankruptcy. Next. Times interest, earned. It is calculated. By taking ebit. Over interest, expense. This ratio, is to measure. To what extent current earning of the firm is able to cover current interest, payment. In other words. It shows how many times a company, can cover its interest, charges, on a pre-tax.
Basis. A ratio, of less than 1.0. Implies, that, the firm is very likely to be in default, of making interest, payment. Which can eventually, lead to bankruptcy. For times interest, earned ratio. The higher the better. But, a high ratio, may also indicate, that, a company, has an undesirable. Lack of debt, or is paying down too much debt with earnings, that could be used for other projects. The fourth category. We have profitability. Ratios. For all profitability. Ratios. The higher the better. Gross, profit margin, is calculated. By taking sales, minus cost of goods sold over sales. It measures, how effective, a firm is, in making decision, regarding, pricing, and control, of production, cost. Operating, profit, margin, is calculated. By taking operating, income over sales. It measures the profitability. Of a firm's operation, before considering, the effects, of financing. Decision. So that, it's suitable, for comparing, the profit, performance, of different firms. That might use varying amount of debt financing. Whilst for net profit, margin. It is calculated. By taking eat, minus, preferred dividend, over sales. It measures, how profitable, a firm is, after deducting, all the expenses. Including, tax and interest. Net profit, margin, shows how much profit is available, to common stockholders. That's why, potential, investors, are interested, in these ratios. As profit, level is tied to the sustainability. Of a firm. It is a good signal if it is higher than the industry, average. However. This ratio, may be subject, to earnings manipulation. For example. The company may sell products, to shell companies. Which means the fake companies. Without, collecting, money and record at his revenue. This could produce misleading. Results, to the investors. Another, profitability. Ratio, is operating, income return on investment. Calculated. By taking operating, income over total assets. It measures how effectively, a company, is in using its assets, to generate, earnings, before paying interest, and taxes. Return, on asset. Roa. Is also called return, on investment. Roi. It is calculated. By taking eat, minus preferred, dividend, over total assets. It measures how effectively, the company, is, in converting, its investment, in assets, into net income. Return, on equity. Roe. Is calculated. By taking eat, minus preferred dividend, over common equity. It is also known as return, on net worth. This is to reveal how much profit a company, generates, with the money shareholders, have invested. However. Roe, is directly, influenced, by the amount of debt used by the company. Sometimes. High roe, may simply reflect, greater proportion, of debt leverage, used by the firm. For high growth companies. We should expect, a higher roe. The roe, is useful for comparing, the profitability. Of a company to other firms, in the same industry. Next we have earnings, per share. Eps. It is calculated. By taking earnings, available, to stockholders. Over number of common stock, outstanding. Eps. Shows the portion of a company's, profit. Allocated, to each outstanding. Share of common stock. If two companies, could generate, the same eps, number, but one could do so with less equity investment. This would mean that, the company with less equity would be more efficient, at using its capital, to generate, income. So, it would be a better company. If operating, cash flow per share is greater than the reported, eps. Earnings, are of a high quality. Because the company, is generating, more cash than is reported, on the income statement. And vice versa. As a summary for the profitability. Ratios. They can be divided, into three types. First. Profit, over sales. Including. Gross profit, margin. Operating, profit, margin. And net profit, margin. Second. Profit over assets. Including. Operating, income return on investment. And return on asset. Third. Profit over equity. Which is return, on equity. The last category, is, market, value, ratios. It provides, an assessment, of performance, as perceived, by the financial, market. These ratios, should parallel, with the accounting, ratios, for that firm.
For Example. If the accounting, ratio, suggests, that, a firm has more risk than average firm in the industry. And lower profits, prospect. This information, should reflect, on a lower market, price of that firm's stock. Price to earnings. P e ratio. Is calculated. By taking market price per share over earnings per share. This ratio, measures the current, share price, relative to its per share earnings. It indicates, the dollar amount an investor, can expect to invest in a company. In order to receive, one dollar of that company's, earnings. Sometimes, it is referred, as the multiple. Because it shows how much investors, are willing to pay per dollar of earnings. A high p e suggests, that investors, are expecting, higher earnings, growth in the future. The last one we have, price to book. Pb, ratio. It is calculated. By taking market price per share over book value per share. To calculate, book value per share, we take common equity over number of common stock outstanding. This ratio, reflects, the perception, of the company by investors. If the value, is significantly. Lower than one, the potential, productive, capacity. Of assets, is assessed by investors. Is insufficient. It is due to the amount of risk associated. With the type of activity. And the volume of the share capital. So far. We have already, covered five categories. Of financial, ratios. Although financial, ratio, analysis. Is very useful. It is subject, to some limitations. Different firm may have applied, a different accounting, policy. Different firm may have a different accounting, year end. It does not take inflation, into account. Year and figure, financial, statements, may not truly be representative. Of the whole year. Information. Of financial, statements, becomes, available, very late. Ratios. Are only a guide, they are not definitive, or conclusive. Some ratios, have more than one formula. All right, that's all for this video. Thanks for watching. See you in the next one. Bye.