Overview
This lecture covered financial ratios and how to use them to analyze a company's performance, focusing on liquidity, profitability, and efficiency metrics using Smart Touch Learning as an example.
Liquidity Ratios
- Liquidity ratios measure a company’s ability to meet short-term obligations.
- The current ratio is calculated as current assets divided by current liabilities.
- The quick ratio (acid-test ratio) excludes inventory from current assets for a stricter test of liquidity.
Profitability Ratios
- Profitability ratios assess a company's ability to generate earnings.
- The gross profit margin is gross profit divided by net sales.
- The net profit margin measures net income divided by net sales.
- Return on assets (ROA) is net income divided by average total assets, showing how well assets are used to generate profit.
- Return on equity (ROE) is net income divided by average shareholders’ equity, indicating returns generated for owners.
Efficiency Ratios
- Efficiency ratios evaluate how well a company uses its assets and liabilities.
- Inventory turnover is calculated as cost of goods sold divided by average inventory, showing how often inventory is sold.
- Receivables turnover is net credit sales divided by average accounts receivable, measuring how quickly receivables are collected.
- Days’ sales in receivables estimates the average number of days to collect receivables.
- Asset turnover is net sales divided by average total assets, showing sales generated per dollar of assets.
Other Key Calculations
- Earnings per share (EPS) is calculated as net income divided by the weighted average number of shares outstanding.
- Debt ratios, such as the debt-to-equity ratio, compare total liabilities to shareholders’ equity to measure financial leverage.
Key Terms & Definitions
- Liquidity — a firm’s ability to pay its short-term debts as they come due.
- Profitability Ratios — metrics that show a company’s ability to generate profit.
- Efficiency Ratios — ratios that indicate how effectively a company uses its assets.
- Current Ratio — current assets ÷ current liabilities.
- Quick Ratio — (current assets – inventory) ÷ current liabilities.
- Gross Profit Margin — gross profit ÷ net sales.
- Net Profit Margin — net income ÷ net sales.
- Return on Assets (ROA) — net income ÷ average total assets.
- Return on Equity (ROE) — net income ÷ average shareholders’ equity.
Action Items / Next Steps
- Practice calculating each ratio using provided financial statements.
- Review definitions and interpretations for each ratio.
- Prepare for a quiz on liquidity, profitability, and efficiency ratios.