Hey guys, I am Derek, welcome to my channel. In this video, I'm gonna talk about financial ratio analysis. Financial ratio analysis involves methods of calculating and interpreting financial ratios, and this is 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.
Net profit of company A is $100,000, whilst for company B is $10,000. 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 $1 million, whilst for 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 for company B is 50%. Now, it is obvious 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 the performance of many companies in the same year. About 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 that's called benchmarking. In the following part, we are going to introduce 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 its 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.
Fourth, 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. Now, 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 showing better liquidity.
It could be due to high inventory level that causes current assets to increase, indicating a firm's problem in inventory turnover. That's why we have another formula for liquidity, the acid test ratio, or quick ratio, which is more stringent as the 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, and 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 almost the same.
Why? The reason is because, Company A does not keep much inventory compared to the other two companies. Therefore, Company A is more liquid.
The next is activity ratios. They are also known as efficiency or asset management ratios. Accounts receivable turnover is calculated by taking credit sales over accounts receivable, in which accounts receivable means the amount of money that customers have not yet paid back. Accounts receivable turnover shows the number of accounts receivable a company collects during a year. In other words, it shows how many times the customers make payment to the company during a year.
For accounts 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 accounts receivable over credit sales times 365 days.
Average collection period shows the average number of days accounts receivable remains outstanding, or it means how many days it takes for customers to make payment. The shorter, the better. Shorter average collection period means Customers take shorter days to pay back money. Higher accounts receivable ratio or shorter average collection period may imply the following.
A company operates more on a cash basis. When customers pay by cash, then accounts receivables will reduce. So, accounts receivable turnover ratio will become higher.
A company is efficient in the collection of accounts receivable, which means the company can collect outstanding balances pretty quickly. probably through frequent reminders, clear invoicing, and timely follow-up on late payments. The company has high proportion of quality customers in which the customers are reliable and financially stable. So, these customers are more likely to pay their bills on time, resulting in faster collections and a higher turnover ratio.
The company has a conservative credit policy regarding its extension of credit. For example, the company offers a shorter credit term to its customers by requesting them to pay in a shorter period, which may result in faster collections and a higher accounts receivable turnover ratio. The company may only extend credit to customers with a good credit history and prompt payment records.
Industry norms in which the accounts receivable turnover ratio can vary depending on the industry. For example, some industries, such as retail, have shorter payment terms which can lead to a higher turnover ratio. Therefore, a high accounts receivable turnover ratio in one industry may not necessarily be considered high in another industry. Next, accounts payable turnover. It is calculated by taking credit purchases over accounts payable, in which accounts payable means the amount of money that the company has not paid back to the suppliers.
Accounts Payable Turnover shows the number of accounts payable a company pays during a year. In other words, it shows how many times the company makes payment to the suppliers during a year. For Accounts Payable Turnover, the higher the better.
Higher Accounts Payable Turnover helps the company build a good credit with the suppliers. Another alternative is to convert the Accounts Payable Turnover into Average Payment Period. Average payment period is calculated by taking accounts payable over credit purchases times 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 accounts payable turnover ratio. This ratio may affect the supplier's decision of giving how much credit sales and how long credit terms to the company. Higher accounts payable turnover ratio or shorter average payment period may imply the following.
A company has an efficient accounts payable process so that it can process and pay invoices more quickly, resulting in a higher accounts payable turnover ratio. A company is taking advantage of early payment discounts offered by suppliers, causing it to pay invoices more quickly to obtain the discount. Fast-moving consumer goods industry, such as retail industry, usually has shorter payment periods than others.
Since the company receives cash more quickly from its customers, it will be able to pay the suppliers more quickly as well. Next, inventory turnover. It can be calculated by taking cost of goods sold over average inventory. Inventory turnover shows how many times a company's inventory is sold or replaced over a period. Similar to other formulas of turnover ratio, 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 average inventory over cost of goods sold times 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 buying outdated products. For inventory turnover ratio, Usually we apply average inventory figure. To calculate average inventory, we take beginning inventory plus ending inventory divided by 2. This is to average out any seasonality effects on the ratio.
Seasonality effects mean certain months the company may have higher inventory while others may have lower inventory. A low inventory turnover or long holding period is usually a bad sign because products tend to deteriorate. or become obsolete as they sit in a warehouse. A high inventory turnover or short holding period may imply the following. The company is selling perishable items such as groceries.
The company is running out of stock due to high demand of the products, which may cause losing sales to its competitors. Next, 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. Higher asset turnover ratio indicates that a company has more effectively utilized fixed asset investments 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. There are some factors affecting how much to invest in fixed assets. These factors include cost of assets required and how long to be used.
The longer the assets will be used, the more it makes sense to invest in them. The depreciation policy, such as straight-line method or accelerated method. For accelerated method, net fixed asset value may decrease more. Extent of assets being leased or owned. Leasing can be a good option if the company does not want to tie up too much cash in fixed assets.
Technology used, for example, different companies in the same industry may adopt different technologies. The technology used can affect the efficiency of the assets and the overall productivity of the company. A manufacturing company may invest more in fixed assets, while a social media company such as Facebook may be lesser.
That's why social media companies tend to have higher fixed assets turnover ratios, which is not comparable to other industries. The next category, 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 has higher financial risk, while lower debt ratio shows lower financial risk. Bondholders 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 to the bondholders and creditors 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 or during low seasons. Low seasons happen when the company has low revenues.
Next, debt-to-equity ratio, calculated by taking total debt over common equity. It measures a company's debt relative to the total value of its stock. A high debt-to-equity ratio generally means that a company has been aggressive in financing its growth with debt. For taking higher debt, the 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, then the 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 next category, 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 it is suitable for comparing the profit performance of different firms that might use varying amount of debt financing. However, 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. 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 but record it as revenue. This could produce misleading results to the investors.
Another profitability ratio is operating income return on investment, which is calculated by taking operating income over total assets. It measures how effectively a company is in using its assets to generate earnings before paying interests 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 asset investment 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, Earnings Per Share, EPS.
It is calculated by taking earnings available to stockholders over number of common stocks outstanding. EPS shows the portion of a company's profit allocated to each outstanding share of common stock. In other words, EPS is a measure of how much profit a company makes per share of its 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. Simply speaking, the company is able to use less money to make profit.
so it would be a better company. If operating cash flow per share is greater than the reported EPS, that means the earnings are of a high quality, because the company is generating more cash than is reported on the income statement, which is a good sign. But if the operating cash flow per share is lower than the EPS, it means the company might not be making as much money as it seems on paper. 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 asset, 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 the firm's performance as perceived by the financial market. These ratios should parallel with the accounting ratios for that firm. For example, if the accounting ratios suggest 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 ratio or 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 tells you how much money an investor needs to invest in a company in order to get $1 of profit that the company makes. 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 ratio shows that investors are expecting higher earnings growth in the future. Next, price-to-book ratio, P-B 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 compares the price of a company's stock to the value of its assets, reflecting the investor's perception on the company. If the ratio is less than 1, it means that investors think the company's assets are not worth enough to justify the stock price.
This could be because the company is taking on a lot of risk or doesn't have enough money invested in the business. Therefore, investors have low confidence to invest in the company as they may not think it is a good opportunity to make money. The company's assets may not generate enough profits in the future to justify the current stock price. Although financial ratio analysis is very useful, it is subject to some limitations that must be taken into consideration when interpreting the results of the analysis. Different firms may use different accounting policies, such as depreciation methods or inventory valuation methods, which can affect the values of the financial ratios.
For example, one company may use the FIFO method to value its inventory, while another company may use the LIFO method. These differences can make it difficult to compare the financial ratios of different companies. Different firms may have different accounting year-ends, which can also affect the values of financial ratios. For example, if one company has an accounting year-end of December 31, while another company on March 31, it may be difficult to compare their financial ratios on a year-to-year basis. Financial ratio analysis does not take inflation into account, which means that the values of financial ratios can be distorted over time.
For example, if a company's revenue has increased by 5% over the past year, it may appear to be a positive sign. However, if inflation has increased by 6% over the same period, the company's real revenue has actually decreased. The year-end figures of financial statements may not be truly representative of the whole year. For example, a company's financial statements may reflect a strong performance at year-end, but this may be due to a seasonal peak in the business.
As a result, the financial ratios calculated based on year-end figures may not accurately reflect the company's overall performance for the entire year. Information of financial statements becomes available very late. The information is only available after the accounting period ends.
This can make it difficult to use financial ratio analysis as a real-time monitoring tool, as the information may be outdated by the time it becomes available. Ratios are only a guide, they are not definitive or conclusive. So financial ratios should not be used as the sole basis for making financial decisions.
They can provide valuable insights into a company's financial performance. but they should be used in conjunction with other financial analysis tools. Some financial ratios have more than one formula that can be used to calculate them. For example, the current ratio can be calculated as current assets divided by current liabilities or as liquid assets divided by current liabilities. This can make it difficult to compare the financial ratios of different companies as they may be using different formulas to calculate the same ratio.
All right, that's all for this video. Thanks for watching. See you in the next one. Bye