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FINANCIAL RATIOS: How to Analyze Financial Statements | Accounting Stuff | YouTubeToText
YouTube Transcript: FINANCIAL RATIOS: How to Analyze Financial Statements
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Hello i'm James you're watching Accounting 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 ambitiousI 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 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 profit 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
businesses 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 owners 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 it's 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 R-O-C-E. '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...
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 they are a businesses obligations that need to be
settled within one 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 it's
inventory over a period of time. Rhe 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 it's 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 maximize 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 the 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 it's Earnings per Share
then we find its Price-to-Earnings Ratio also known as the 'P/E 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 P/E 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 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.
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