Financial ratio analysis — Transcript

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1. 0:00How does financial ratio analysis work?
2. 0:04Let’s discuss ten of the most popular financial ratios that can help you find the story behind
3. 0:10the numbers.
4. 0:12What do you need to get started on a financial ratio analysis?
5. 0:16You need an income statement,
6. 0:18the overview of how much profit a company made during a year.
7. 0:22You also need a balance sheet, an overview of what a company owns and what a company
8. 0:26owes at a specific point in time.
9. 0:30We will start off with financial ratios that only focus on the income statement, then look
10. 0:35at financial ratios that only focus on the balance sheet, and end with powerful financial
11. 0:40ratios that combine information from the income statement and the balance sheet.
12. 0:46Performing a financial ratio analysis has a scientific element to it (finding data and
13. 0:52putting it into formulas), as well as an artistic element (assigning meaning to the outcome
14. 0:57of the calculations, and seeing the big picture).
15. 1:01Part 1: financial ratios that only focus on the income statement,
16. 1:06or profit and loss statement (P&L).
17. 1:10Let’s compare the income statements of two fictitious companies, which unlike real life
18. 1:16companies have nice round numbers in their financial statements.
19. 1:21The first step in financial ratio analysis of the income statement,
20. 1:25is to make everything relative.
21. 1:27Relative to sales that is.
22. 1:30Each of the cost line items and profit subtotals is expressed as a percentage of revenue.
23. 1:36Let’s see what the financial ratios tell us.
24. 1:40Company A has a Gross Profit margin of 50%, company B of 30%, so the Gross Profit margin
25. 1:47is 20%-points higher for company A. Company A makes far more margin than company B on
26. 1:55the products or services it sells.
27. 1:59Company A has an Operating Margin of 21%,
28. 2:01while company B has an Operating Margin of 14%.
29. 2:05So the 20%-point difference (50% versus 30%) on the Gross Profit level has shrunk to 7%-points
30. 2:14(21% versus 14%) on the Operating Margin level.
31. 2:20Net income as percentage of sales (often called “Return On Sales”) is 16% for company
32. 2:25A, and 8% for company B. What do we zoom in on for further analysis?
33. 2:32Let’s investigate the difference between Gross Profit and Operating Margin.
34. 2:38This is mainly driven by selling, general and administrative expenses: 20% of revenue
35. 2:43in company A, 10% of revenue in company B. The non-manufacturing costs for functional
36. 2:49departments like sales, marketing, finance, HR, sourcing, legal and IT are far higher
37. 2:56for company A than for company B.
38. 3:00This could be related to the industry each company is in, the company’s strategy, or
39. 3:04the level of efficiency that it has achieved.
40. 3:07Could company A be overspending in SG&A, or is company B underspending?
41. 3:13Hard to say just from these numbers, but worth investigating!
42. 3:19On the Research and Development line, company A is spending more than company B.
43. 3:23This is usually seen as a good thing, as today’s Research and Development expenses hopefully
44. 3:29lead to high margin innovative products and services to sell in the future.
45. 3:34Part 2: financial ratios that only focus on the balance sheet.
46. 3:40The first question that I always ask myself is: how is the company doing on liquidity,
47. 3:45is it likely to be able to pay its bills in the short term?
48. 3:49Let’s look at the current assets (cash plus items that are likely to convert to cash within
49. 3:55a year) versus the current liabilities (items that need to be paid with cash within a year).
50. 4:01A useful financial ratio in this area is the current ratio: simply divide the current assets
51. 4:08by the current liabilities.
52. 4:10For company A, 400 divided by 200 is 2.
53. 4:15For every dollar of current liabilities, there are two dollars of current assets, a “safe”
54. 4:20position (from the perspective of business continuity).
55. 4:24For company B, 200 divided by 400 is 0.5.
56. 4:29For every dollar of current liabilities, there is only 50 cents of current assets, a “more
57. 4:34risky” position (for a supplier that is hoping to get paid).
58. 4:40While on the topic of current assets and current liabilities, let’s calculate the amount
59. 4:44of working capital utilized by the companies: accounts receivable plus inventories minus
60. 4:50accounts payable.
61. 4:52For company A, this is 150 plus 200 minus 200, in total 150.
62. 5:00For company B, this is 50 plus 100 minus 300, in total negative 150.
63. 5:08Company B seems to be getting paid by customers before they have to pay suppliers, and holds
64. 5:13a low level of stock.
65. 5:16The next financial ratio is all about the companies’ financing strategy: does it primarily
66. 5:22borrow money to finance operations, or rely on capital provided by the shareholders?
67. 5:28The debt-to-equity ratio can help you put that in perspective.
68. 5:32For company A, 100 in borrowings, 700 in equity, so a debt-to-equity ratio of 1 to 7.
69. 5:40You could call this a conservative and robust way of financing, with a big buffer of equity
70. 5:45that helps defend the business continuity of the company in case of future losses.
71. 5:51For company B, 400 in borrowings, 100 in equity, so a debt-to-equity ratio of 4 to 1.
72. 5:59For every dollar of shareholder capital (equity), there are four dollars borrowed, which is
73. 6:04possibly more fragile.
74. 6:08A related financial ratio is equity as percentage of the balance sheet total.
75. 6:1370% for company A, 12.5% for company B. Based on the debt-to-equity ratio, and equity as
76. 6:21percentage of total, you could say that company A has a low leverage, while company B has
77. 6:27a high leverage.
78. 6:30Part 3: financial ratios that combine information
79. 6:33from the income statement and the balance sheet.
80. 6:37This is where you might see new storylines and connections, on top of what you discovered
81. 6:42in analyzing the income statement individually and the balance sheet individually.
82. 6:46Let’s start with a “big picture” financial ratio called Return On Equity, which is Net
83. 6:52Income divided by Equity.
84. 6:55For company A, 160 divided by 700, which is 22.9%.
85. 7:01For company B, 80 divided by 100, which is 80%.
86. 7:07On the Return On Equity metric, company B far outperforms company A.
87. 7:12What is driving that?
88. 7:16While company A has higher profit margins (as we saw in the income statement analysis),
89. 7:21company B has a much higher financial leverage (as we saw in the balance sheet analysis).
90. 7:26There is a third component to the Return OnEquity calculation:
91. 7:29the financial ratio called asset turnover.
92. 7:35Asset turnover looks at how much revenue is generated by the company
93. 7:38with the assets it has.
94. 7:41For company A, asset turnover is 1.
95. 7:441000 in assets on the balance sheet generates 1000 in revenue in the income statement.
96. 7:50For company B, asset turnover is 1.25.
97. 7:53Let’s dig a little deeper into two key subsets of this asset turnover ratio.
98. 8:01The first one is receivables turnover: the number of times per year that a business collects
99. 8:06its average accounts receivable, the ratio between revenue in the income statement and
100. 8:11accounts receivable on the balance sheet.
101. 8:146.67 for company A, 20 for company B. Receivables turnover might be a bit abstract for a lot
102. 8:22of people, so let’s turn it into a more tangible related metric called Days Sales
103. 8:27Outstanding: how many days does a company need to wait before a customer pays.
104. 8:3355 days for company A, and just 18 days for company B.
105. 8:38The second subset of the asset turnover ratio is inventory turnover:
106. 8:42the number of times per year that a business turns
107. 8:46its inventory, the ratio between revenue in the income statement
108. 8:50and inventory on the balance sheet.
109. 8:525 inventory turns for company A, 10 inventory turns for company B.
110. 8:59So what do financial ratios tell us?
111. 9:01Can we say, based on calculating these financial ratios that company A is in better financial
112. 9:07shape, or company B is in better financial shape?
113. 9:10Not necessarily.
114. 9:12Financial ratios do provide us with clear information about the financial footprint
115. 9:17of a company, and deepen your understanding of the strategic and operational story behind
116. 9:22the financial numbers.
117. 9:25In this video on financial ratio analysis, we covered ten financial ratios:
118. 9:30On the income statement: gross profit %, operating margin %, return on sales %
119. 9:38On the balance sheet: current ratio, debt-to-equity, equity as % of total
120. 9:45When linking the P&L and the balance sheet: return on equity, asset turnover, receivables
121. 9:51turnover, inventory turnover Financial ratio analysis is as much an art
122. 9:57as it is a science!
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125. 10:07Thank you.