Hello, I'm James, you're watching Counting Stuff and today we're covering financial ratios. I'll explain what financial ratios are, we'll break them down into five main groups, and then I'll show you how to work out 25 financial ratios in 25 minutes. Ambitious, I know, but we've got this! Before we get started, I want to say a big thanks to all my channel members. Your support is always appreciated.
Thank you. Financial statements. Financial ratio analysis begins with financial statements, accounting reports that summarize the financial activities and performance of a business.
The three main financial statements are the income statement, the balance sheet and the cash flow statement. However, we can work out most financial ratios using only the income statement and the balance sheet. The income statement looks like this. It gives us a summary of a business's revenues and expenses over a period of time. And then we have the balance sheet which gives us a snapshot of a business's assets, liabilities and equity at a point in time.
So what is financial ratio analysis? Good question! A ratio tells us how much of one thing we have compared to another thing.
In a financial ratio we compare the size of one line in a financial statement against another. Usually we can find these line items in the income statement or the balance sheet. And most of the time financial ratios are shown as percentages. Whenever that's the case we multiply by 100. Financial ratio analysis is the process of comparing different financial ratios over time and across different businesses.
What types of financial ratio are there? I like to break them down into five main groups. Profitability ratios, liquidity ratios, efficiency ratios, leverage ratios and price ratios. Now I'll show you how to work out 25 of the most popular financial ratios that live in each of these groups. If you want to make some notes, then now might be a good time to grab yourself a pen and paper.
Or if you'd like to stay focused on this video, I've made some financial ratios cheat sheets that summarize pretty much everything I'm about to cover. You can find them on my website, the link is down in the description and the proceeds help support this channel. We'll kick things off with profitability ratios. Profitability ratios measure how efficiently a business generates profit from four different things. Revenue, assets, equity and capital employed.
We can break them down into margin ratios and return ratios. Margin ratios measure how well a business converts revenue into profit. We can calculate margin ratios using one simple formula.
Profit margin is equal to profit divided by revenue. Profit and revenue live in the income statement. Revenue is on the top line. It's the earnings that a business generates over a period of time.
And Profit is the financial gain left in the business after deducting expenses. As you can see, there are three types of profit in an income statement. Gross profit, operating profit, and net profit. Gross profit is the big one at the top. It's a business's revenue minus its cost of sales.
And if we take gross profit and divide it by revenue, then we can find a business's gross profit. profit margin, which is the first of our 25 financial ratios. Gross profit margin tells us how much big profit a business is able to generate from each dollar of revenue earned.
It's a similar story with the other margin ratios. If we move further down the income statement and subtract operating expenses as well, then we get to operating profit. Operating profits divided by revenue gives us our second financial ratio, operating profit margin. And if we head down to the bottom line of the income statement, we have net profit. This is the residual profit that's left over after deducting all of the business's expenses.
And net profit divided by revenue is, you guessed it, net profit margin. Our third margin ratio. If you'd like to learn about these in a bit more depth, I've made videos covering each of these ratios. I plan to do the same for the rest of the financial ratios in this playlist. So don't forget to subscribe if you'd like to watch those.
But what about return ratios? Return ratios work in a similar way, but this time we have net profit on the top of the equation. As we saw a moment ago, net profit can be found on the bottom line of an income statement. In a return ratio, we measure how much net profit a business is able to generate relative to its assets, equity, or capital employed. We can find all three of these in the balance sheet.
Assets make up the left-hand side of a balance sheet. Total assets represent all of the stuff that a business owns at a point in time. If we take a business's net profit from the income statement and divide it by total assets from the balance sheet, then we've calculated its return on assets or ROA.
Hold up, I want to point out one thing. When we compare a line item from the income statement against a line item from the balance sheet like we have here, it's a good idea to use the average balance sheet number. This is because the balance sheet is a snapshot at a point in time, whereas the income statement covers a period of time.
If we average the opening and closing balance sheet numbers, then we can compare like with like. I won't mention this every time it comes up, but please keep it in mind. On the right hand side of the balance sheet we have liabilities and equity. Together these represent the stuff that a business owes. A business owes liabilities to third parties and it owes equity back to its owners.
Total equity is the owner's or shareholders claim on the net assets of the business and return on equity or ROE is equal to a business's net profit divided by its total equity. Return on equity shows us how efficiently a business uses its owner's money to generate bottom line profit. But there's a problem. Some businesses choose to take out very large loans to fund their operations. This reduces the owner's claim on net assets and it can inflate return on equity.
In these situations it can be better to use capital employed. Capital employed is a business's total asset minus its current liabilities. It ignores all long-term debt used to fund operations.
Net profit divided by capital employed is return on capital employed or ROCE. ROCE can even go a step further and use operating profit instead of net profit. So return on capital employed is equal to a business's earnings before interest and tax divided by its capital employed.
At number six, this is our last return ratio and our last profitability ratio. Let's move on to liquidity ratios. Liquidity ratios measure how well a business can cover its short-term debt obligations using different assets. The calculation looks something like this. like this.
A liquidity ratio is equal to some assets divided by current liabilities. These assets on the top are used to cover a business's short-term debt obligations on the bottom. Everything you see here can be found on the balance sheet which makes things nice and simple. Current liabilities can be found on the right-hand side of a balance sheet. There are businesses obligations that need to be settled within one year.
year. On the left we have assets. Liquid assets are the stuff that a business owns that can be converted into cash quickly and easily. The most liquid asset of them all is cash itself. If we take cash and divide it by current liabilities then we have the cash ratio.
If the cash ratio is bigger than one then a business is able to pay off all its short-term debt obligations with the cash that it has on hand. This is an indicator of good financial health. But it isn't always possible. Sometimes we need to look at all of the business's liquid assets on the balance sheet.
So that means cash, marketable securities like short-term investments, and accounts receivable. Inventory and prepaid expenses aren't considered to be liquid assets. We can find the quick ratio by taking all liquid assets and dividing them by current liabilities. This checks if a business can cover its short-term debt obligations using everything that can quickly be converted into cash. But we can go a step further too.
We can consider all of a business's current assets, including inventory and prepaid expenses. That gives us the current ratio. Current assets divided by current liabilities.
This is our ninth financial ratio and the last of our liquidity ratios. Now let's move on to efficiency ratios. Efficiency ratios measure how effective a business is at selling inventory to customers, how quickly it's able to collect cash back from them, and how reliably it pays off its creditors.
There are two parts to this. We have turnover ratios and we have the cash conversion cycle. Turnover ratios measure how quickly a business conducts its operations. They compare one line from the income statement against a related line in the balance sheet. Take the inventory turnover ratio, for example.
In this one, we divide cost of goods sold in the income statement by inventory in the balance sheet. The inventory turnover ratio tells us how many times a business has sold and replenished its inventory over a period of time. The receivables turnover ratio works in a similar way.
This time we divide revenue in the income statement by accounts receivable in the balance sheet. This one measures how efficiently a business collects cash from its customers. If we instead divide revenue by total assets from the balance sheet, then we also have the asset turnover ratio. This one may feel familiar because it's not too different to return on assets which we covered in profitability ratios. That was net profit divided by total assets.
In this one however, the asset turnover ratio ignores expenses and focuses on revenue, and how efficiently a business generates revenue using the stuff it owns. Then we have the payables turnover ratio, which is cost of goods sold from the income statement divided by accounts payable in the balance sheet. The payables turnover ratio shows us how reliably a business pays off its suppliers. It's our last turnover ratio.
Onward to the cash conversion cycle. The cash conversion cycle tells us the average number of days a business needs to convert its investments in inventory into cash. It works like this.
The cash conversion cycle is equal to days sales of inventory plus days sales outstanding plus days payable outstanding. These three cash conversion ratios are the upside down of turnover ratios. Days sales of inventory is the upside down version of the inventory turnover ratio.
This time we have inventory from the balance sheet on the top and cost of goods sold from the income statement on the bottom. But this time round we multiply the ratio by 365, the number of days in a year. When we do this, we get the average number of days it takes a business to convert its inventory into sales, also known as the inventory turnover period. Days sales outstanding is the inverse of the receivables turnover ratio.
It's accounts receivable from the balance sheet divided by revenue from the income statement. When we multiply it by 365, it tells us the receivables collection period. The average time it takes a business to collect a payment from a sale in days. And last but not least, we have days payable outstanding, which is basically the payables turnover ratio upside down.
Days payable outstanding is accounts payable from the balance sheet divided by cost of goods sold. from the income statement times 365. It's the average payables payment period. The number of days it takes a business to pay its bills. Days payable outstanding is our 16th financial ratio and closes the loop on the cash conversion cycle. How long it takes a business to turn over inventory, collect cash on sales and pay bills.
Leverage ratios. Leverage is when you up your risk by taking on debt in order to maximise your return or reward. Leverage ratios can be split out into two categories.
balance sheet ratios and income statement ratios. Leverage ratios in the balance sheet divide total liabilities by total assets or total equity. If we take total liabilities and divide them by total assets then voila!
We have the debt to assets ratio, the DTA ratio. This tells us how much of a business's assets have been financed using debt. This ratio considers both short and long-term debt obligations. If we jump back to total liabilities in the balance sheet and divide them this time by total equity then we've got the debt to equity ratio, DTE.
This tells us how much debt a business has for each dollar of equity. A business can finance its assets by either borrowing money from third parties or using its owner's own money. Raising debt can be helpful since it uses leverage to expand a business, but it comes with some risk in the form of interest.
Which leads us nicely into interest ratios, which we can find in the income statement. These determine a business's ability to meet its financial obligations. We take a type of profit and divide it by a type of interest.
Both can be found in the income statement. The interest coverage ratio compares a business's operating profit against its interest expenses. Operating profit is calculated before interest so this tells us whether a business has earned enough profit to cover the interest on its debt obligations. But being able to cover interest isn't the whole story.
Total debt service is made up of interest and repayments of the principal, the current portion of long-term debt. So it's also worth checking the debt service coverage ratio, which is equal to EBITDA divided by total debt service. EBITDA is earnings before interest, tax, depreciation and amortization. This ratio uses EBITDA instead of operating profit because it excludes depreciation and amortization, which are both non-cash expenses. It tells us whether a business generates enough profit to service both the interest and principal repayments on its debt.
And that's a wrap on leverage ratios. But don't go anywhere just yet. We have one last group to cover.
Price ratios. Price ratios are very important. Investors use them in financial analysis to evaluate the share price of a business and determine if it's a worthwhile investment.
Price ratios tend to fall into two groups. We have earnings-based ratios and dividend-based ratios. We'll start with earnings-based ratios.
You've probably heard of this one, earnings per share or EPS. It's a business's net profit divided by the number of common shares outstanding. Earnings per share represents the slice of a business's profit that's allocated to each share of common stock. The number of common shares outstanding can be found in the equity section of a business's balance sheet, either in the note for common stock or in the line item description. And as we've seen, Net profit can be found on the bottom line of the income statement.
Sometimes the EPS calculation is net profit minus preferred dividends divided by common shares outstanding. This is because dividends are distributed to preferred shareholders before common shareholders. Earnings per share is a useful way to measure profitability, but it doesn't give us the whole picture.
If we take a business's share price and divide it by its earnings per share, then we find its price to earnings ratio, also known as the PE ratio. A business's share price can be found quickly online. It's the lowest amount you can buy one unit of company stock for. In a publicly traded company that's listed on a stock exchange, share prices fluctuate constantly and are determined by the market.
The P.E. ratio is share price divided by earnings per share. So it tells us how much the market is prepared to pay for each dollar of earnings.
Share prices can be overvalued which can lead to a large price to earnings ratio. However, a high P-E ratio could indicate strong future growth. Which brings me on to the next financial ratio.
The price to earnings to growth or PEG ratio. This is equal to the price to earnings ratio which we just covered divided by the expected earnings per share growth. EPS growth is an estimate and represents the projected annual growth rate in earnings per share.
So the PEG ratio delves a little deeper into determining an investment's value than the PE ratio. In theory, it tells us if a company's stock is overvalued, undervalued or priced correctly, given the expected future growth rate. I say in theory because the validity of the PEG ratio is completely dependent on the EPS growth rate which, like I mentioned, is an estimate.
Moving on, moving on. What about dividend-based ratios? Dividends per share is calculated in a very similar way to earnings per share but this time we swap out net profit on the top for dividends paid.
So DPS is equal to dividends paid divided by the number of common shares outstanding. Dividends are cash distributions paid out to the shareholders of a business over a period of time. This makes dividends per share an important ratio because dividends are effectively income from an investor's point of view. If a business pays out a special dividend, which is a non-recurring extra dividend related to a particular share, it is a non-recurring extra dividend.
particular event, then we should deduct it when working out dividends per share. Another handy formula for investors is the dividend yield ratio. In this one, we take dividends per share and divide it by the share price of the company. This represents the percentage of a business's share price that it tends to pay out in dividends each year. And that's our 25th financial ratio.
However, since you've made it this far I do have one extra bonus one for you. It's called the dividend payout ratio and we calculate it by taking dividends paid and dividing it by the net profit earned over the same period of time. This represents the percentage of a business's net profit that's distributed back to the shareholders as a dividend.
Another useful ratio for investors. And at number 26 this is our last price ratio which completes our mind map of financial ratios. We covered profitability ratios which measure how efficiently a business generates profit. Liquidity ratios which tell us if a business can cover its short-term debt obligations.
Efficiency ratios which show us how quick they are at selling inventory, collecting cash and paying off creditors. And then there was leverage ratios which measure how much debt a business has taken on and its ability to service that debt. And finally price ratios are used by investors to evaluate the share price of a business to see if it's a worthwhile investment. OMG that was a lot to take in.
I've summarized all this information in my financial ratios cheat sheets. If you think they could come in handy then you can find them on my website and I will see you. in the next video.