FINANCIAL RATIOS: How to Analyze Financial Statements

James, from Accounting Stuff, delves into the concept of Financial Ratios, breaking them down into five primary categories: Profitability, Liquidity, Efficiency, Leverage, and Price Ratios. He explains how these ratios, derived mainly from the Income Statement and Balance Sheet, provide insights into a business's financial health and performance. James demonstrates how to calculate 25 key ratios, including Profit Margins, Return Ratios, and Leverage Ratios, while emphasizing their importance for business analysis and investment decisions. He also offers Financial Ratios Cheat Sheets for further study and practical application.

• Financial Ratios are tools used to analyze financial statements, which summarize a business's financial activities and performance.
• The main financial statements include the Income Statement, Balance Sheet, and Cash Flow Statement.
• Most Financial Ratios can be derived from the Income Statement and the Balance Sheet.

"Financial Ratio Analysis begins with Financial Statements accounting reports that summarize the financial activities and performance of a business."

• Financial Ratio Analysis involves comparing different ratios over time and across businesses.

"Financial Ratio Analysis is the process of comparing different Financial Ratios over time and across different businesses."

• Financial Ratios are categorized into five main groups: Profitability Ratios, Liquidity Ratios, Efficiency Ratios, Leverage Ratios, and Price Ratios.

"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."

• Profitability Ratios measure how efficiently a business generates profit from revenue, assets, equity, and capital employed.
• They are divided into Margin Ratios and Return Ratios.

"Profitability Ratios measure how efficiently a business generates profit from four different things: revenue, assets, equity and capital employed."

• Margin Ratios assess how well a business converts revenue into profit.
• Calculated using: Profit Margin = Profit / Revenue.
• Types of profit include Gross Profit, Operating Profit, and Net Profit.

"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."

• Gross Profit Margin: Gross Profit / Revenue, indicates profit generated from each dollar of revenue.

"Gross Profit Margin tells us how much big profit a business is able to generate from each dollar of revenue earned."

• Operating Profit Margin: Operating Profit / Revenue, takes into account operating expenses.

"Operating profit divided by revenue gives us our second Financial Ratio Operating Profit Margin."

• Net Profit Margin: Net Profit / Revenue, shows residual profit after all expenses.

"Net profit divided by revenue is you guessed it! Net Profit Margin our third margin ratio."

• Return Ratios measure net profit relative to assets, equity, or capital employed.
• Net Profit is used as the numerator.

"In a Return Ratio we measure how much net profit a business is able to generate relative to its assets, equity or capital employed."

"As we saw a moment ago net profit can be found on the bottom line of an Income Statement."

• The components such as assets, equity, and capital employed are found in the Balance Sheet.

"We can find all three of these in the Balance Sheet assets make up the left-hand side of a Balance Sheet."

These notes cover the key ideas and themes discussed in the transcript, including the introduction to financial ratios, the types of financial ratios, and a detailed explanation of profitability ratios, including margin and return ratios.

• Return on Assets (ROA): Calculated by dividing net profit from the Income Statement by total assets from the Balance Sheet. It measures how efficiently a company uses its assets to generate profit.

  "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 quote highlights the importance of using average figures from the Balance Sheet to ensure an accurate comparison with the Income Statement, which covers a period of time.

• Return on Equity (ROE): Calculated by dividing net profit by total equity. It indicates how effectively a company uses its shareholders' equity to generate profit.

  "Return on Equity shows us how efficiently a business uses its owner's money to generate bottom line profit."

  • This quote explains that ROE measures the efficiency with which a business utilizes the capital invested by its owners to generate profits.

• Return on Capital Employed (ROCE): Calculated by dividing earnings before interest and tax by capital employed. It measures the efficiency of a company in generating profits from its capital.

  "Net profit divided by capital employed is Return on Capital Employed or R-O-C-E."

  • The quote defines ROCE and explains its calculation, emphasizing its role in evaluating a company's profitability relative to its capital.

• Liquidity Ratios: Measure a business's ability to cover short-term debt obligations using different assets.

  "A Liquidity Ratio is equal to some assets divided by current liabilities."

  • This quote provides the basic formula for liquidity ratios, emphasizing the comparison between assets and liabilities.

• Cash Ratio: Calculated by dividing cash by current liabilities. It indicates a company's ability to pay short-term debts with cash on hand.

  "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."

  • The quote explains that a Cash Ratio greater than one signifies good financial health, as it indicates sufficient cash to cover short-term debts.

• Quick Ratio: Calculated by dividing liquid assets by current liabilities. It assesses a company's ability to meet short-term obligations without relying on inventory.

  "We can find the Quick Ratio by taking all liquid assets and dividing them by current liabilities."

  • This quote outlines the calculation of the Quick Ratio, highlighting its focus on liquid assets excluding inventory.

• Current Ratio: Calculated by dividing current assets by current liabilities. It measures a company's capacity to cover short-term liabilities with all current assets.

  "Current assets divided by current liabilities. This is our ninth Financial Ratio and the last of our Liquidity Ratios."

  • The quote defines the Current Ratio and notes its position as the final liquidity ratio discussed.

• Efficiency Ratios: Assess how effectively a business manages its operations, including inventory sales, cash collection, and creditor payments.

  "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."

  • This quote introduces efficiency ratios and their role in evaluating operational effectiveness.

• Turnover Ratios: Measure how quickly a business conducts its operations by comparing Income Statement and Balance Sheet items.

  "Turnover Ratios measure how quickly a business conducts its operations."

  • The quote describes turnover ratios as indicators of operational speed and efficiency.

• Inventory Turnover Ratio: Calculated by dividing cost of goods sold by inventory. It indicates how many times a company sells and replenishes its inventory over a period.

  "The Inventory Turnover Ratio tells us how many times a business has sold and replenished its inventory over a period of time."

  • This quote explains the Inventory Turnover Ratio, which provides insights into inventory management efficiency.

• Receivables Turnover Ratio: Calculated by dividing revenue by accounts receivable. It measures how efficiently a business collects cash from its customers.

  "The Receivables Turnover Ratio works in a similar way. This one measures how efficiently a business collects cash from its customers."

  • The quote explains the Receivables Turnover Ratio, emphasizing its role in assessing cash collection efficiency.

• The Asset Turnover Ratio measures how efficiently a business generates revenue using its assets.
• It is calculated by dividing revenue by total assets from the Balance Sheet.
• This ratio is similar to Return on Assets, but it focuses solely on revenue, ignoring expenses.

"If we instead divide revenue by total assets from the Balance Sheet, then we also have the Asset Turnover Ratio."

• This quote explains the calculation of the Asset Turnover Ratio, emphasizing its focus on revenue generation efficiency.

• The Payables Turnover Ratio assesses how reliably a business pays its suppliers.
• It is calculated by dividing the cost of goods sold from the Income Statement by accounts payable in the Balance Sheet.

"The Payables Turnover Ratio shows us how reliably a business pays off its suppliers."

• This quote highlights the purpose of the Payables Turnover Ratio, which is to evaluate the reliability of a business in paying its suppliers.

• The Cash Conversion Cycle measures the average number of days a business needs to convert inventory investments into cash.
• It is calculated as Days Sales of Inventory plus Days Sales Outstanding plus Days Payable Outstanding.
• Days Sales of Inventory indicates the time taken to convert inventory into sales.
• Days Sales Outstanding measures the average time to collect payment from sales.
• Days Payable Outstanding shows the average time taken to pay bills.

"The Cash Conversion Cycle tells us the average number of days a business needs to convert its investments in inventory into cash."

• This quote explains the function of the Cash Conversion Cycle in assessing the efficiency of converting inventory into cash.

• Leverage Ratios assess the risk taken by a business when using debt to maximize returns.
• They are divided into Balance Sheet Ratios and Income Statement Ratios.
• Debt to Assets Ratio (DTA) measures how much of a business's assets are financed using debt.
• Debt to Equity Ratio (DTE) indicates the amount of debt a business has for each dollar of equity.

"Leverage is when you up your risk by taking on debt in order to maximize your return or reward."

• This quote defines leverage and its purpose in increasing potential returns through the use of debt.

• Interest Ratios determine a business's ability to meet its financial obligations related to interest.
• The Interest Coverage Ratio compares operating profit to interest expenses, assessing if a business can cover its interest obligations.
• Debt Service Coverage Ratio uses EBITDA to evaluate if a business can service both interest and principal repayments.

"The Interest Coverage Ratio compares a business's operating profit against its interest expenses."

• This quote describes the Interest Coverage Ratio and its role in assessing a business's ability to cover interest expenses.

• Price Ratios are crucial for evaluating the value of a business in relation to its market price.
• Although not detailed in the transcript, Price Ratios are implied to be the next topic of discussion.

"Price Ratios are very important."

• This quote underscores the significance of Price Ratios in financial analysis, suggesting their importance in evaluating business value.

• Earnings per Share (EPS): Represents the portion of a company's profit allocated to each share of common stock. Calculated as net profit divided by the number of common shares outstanding. Important for measuring profitability but doesn't provide a complete picture.

  "Earnings per Share or 'EPS' is a business's net profit divided by the number of common shares outstanding."

  • EPS provides insight into the profitability allocated per share, essential for investors assessing company performance.

• Price-to-Earnings Ratio (P/E Ratio): Calculated by dividing a company's share price by its Earnings per Share. Indicates how much the market is willing to pay for each dollar of earnings. A high P/E Ratio might suggest strong future growth potential.

  "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."

  • The P/E Ratio helps evaluate if a stock is overvalued or undervalued based on market expectations.

• Price-to-Earnings-to-Growth (PEG Ratio): This ratio divides the P/E Ratio by the expected EPS Growth. It provides a deeper insight into a stock's valuation by considering expected growth rates.

  "The PEG Ratio delves a little deeper into determining an investment's value than the P/E Ratio."

  • The PEG Ratio accounts for growth expectations, offering a more nuanced view of stock valuation.

• Dividends per Share (DPS): Calculated by dividing dividends paid by the number of common shares outstanding. Reflects the income investors receive from dividends.

  "Dividends per Share is equal to dividends paid divided by the number of common shares outstanding."

  • DPS indicates the dividend income per share, important for income-focused investors.

• Dividend Yield Ratio: Calculated by dividing Dividends per Share by the company's share price. Represents the percentage of the share price paid out as dividends annually.

  "The Dividend Yield Ratio represents the percentage of a business's share price that it tends to pay out in dividends each year."

  • This ratio helps investors understand the return on investment from dividends relative to the stock price.

• Dividend Payout Ratio: Calculated by dividing dividends paid by net profit. Shows the percentage of net profit distributed as dividends.

  "This represents the percentage of a business's net profit that's distributed back to the shareholders as a dividend."

  • The Dividend Payout Ratio reveals how much profit is returned to shareholders, indicating sustainability and company policy on profit distribution.

• Profitability Ratios: Measure how efficiently a business generates profit.

  "We covered Profitability Ratios which measure how efficiently a business generates profit."

  • These ratios assess the company's ability to generate earnings relative to sales, assets, and equity.

• Liquidity Ratios: Indicate whether a business can cover its short-term debt obligations.

  "Liquidity Ratios which tell us if a business can cover its short-term debt obligations."

  • Liquidity Ratios ensure the company can meet its immediate financial responsibilities.

• Efficiency Ratios: Show how quickly a company sells inventory, collects cash, and pays off creditors.

  "Efficiency Ratios which show us how quick they are at selling inventory, collecting cash and paying off creditors."

  • Efficiency Ratios highlight operational effectiveness in managing resources.

• Leverage Ratios: Measure the amount of debt a business has taken on and its ability to service that debt.

  "Leverage Ratios which measure how much debt a business has taken on and its ability to service that debt."

  • These ratios evaluate financial risk and the company's capacity to manage debt.

• Price Ratios: Used by investors to evaluate the share price of a business to determine if it's a worthwhile investment.

  "Price Ratios are used by investors to evaluate the share price of a business to see if it's a worthwhile investment."

  • Price Ratios help investors gauge market valuation and investment potential.