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• How does financial ratio analysis work?

• Let’s discuss ten of the most popular financial ratios that can help you find the story behind

• the numbers.

• What do you need to get started on a financial ratio analysis?

• You need an income statement,

• the overview of how much profit a company made during a year.

• You also need a balance sheet, an overview of what a company owns and what a company

• owes at a specific point in time.

• We will start off with financial ratios that only focus on the income statement, then look

• at financial ratios that only focus on the balance sheet, and end with powerful financial

• ratios that combine information from the income statement and the balance sheet.

• Performing a financial ratio analysis has a scientific element to it (finding data and

• putting it into formulas), as well as an artistic element (assigning meaning to the outcome

• of the calculations, and seeing the big picture).

• Part 1: financial ratios that only focus on the income statement,

• or profit and loss statement (P&L).

• Let’s compare the income statements of two fictitious companies, which unlike real life

• companies have nice round numbers in their financial statements.

• The first step in financial ratio analysis of the income statement,

• is to make everything relative.

• Relative to sales that is.

• Each of the cost line items and profit subtotals is expressed as a percentage of revenue.

• Let’s see what the financial ratios tell us.

• Company A has a Gross Profit margin of 50%, company B of 30%, so the Gross Profit margin

• is 20%-points higher for company A. Company A makes far more margin than company B on

• the products or services it sells.

• Company A has an Operating Margin of 21%,

• while company B has an Operating Margin of 14%.

• So the 20%-point difference (50% versus 30%) on the Gross Profit level has shrunk to 7%-points

• (21% versus 14%) on the Operating Margin level.

• Net income as percentage of sales (often calledReturn On Sales”) is 16% for company

• A, and 8% for company B. What do we zoom in on for further analysis?

• Let’s investigate the difference between Gross Profit and Operating Margin.

• This is mainly driven by selling, general and administrative expenses: 20% of revenue

• in company A, 10% of revenue in company B. The non-manufacturing costs for functional

• departments like sales, marketing, finance, HR, sourcing, legal and IT are far higher

• for company A than for company B.

• This could be related to the industry each company is in, the company’s strategy, or

• the level of efficiency that it has achieved.

• Could company A be overspending in SG&A, or is company B underspending?

• Hard to say just from these numbers, but worth investigating!

• On the Research and Development line, company A is spending more than company B.

• This is usually seen as a good thing, as today’s Research and Development expenses hopefully

• lead to high margin innovative products and services to sell in the future.

• Part 2: financial ratios that only focus on the balance sheet.

• The first question that I always ask myself is: how is the company doing on liquidity,

• is it likely to be able to pay its bills in the short term?

• Let’s look at the current assets (cash plus items that are likely to convert to cash within

• a year) versus the current liabilities (items that need to be paid with cash within a year).

• A useful financial ratio in this area is the current ratio: simply divide the current assets

• by the current liabilities.

• For company A, 400 divided by 200 is 2.

• For every dollar of current liabilities, there are two dollars of current assets, a “safe

• position (from the perspective of business continuity).

• For company B, 200 divided by 400 is 0.5.

• For every dollar of current liabilities, there is only 50 cents of current assets, a “more

• riskyposition (for a supplier that is hoping to get paid).

• While on the topic of current assets and current liabilities, let’s calculate the amount

• of working capital utilized by the companies: accounts receivable plus inventories minus

• accounts payable.

• For company A, this is 150 plus 200 minus 200, in total 150.

• For company B, this is 50 plus 100 minus 300, in total negative 150.

• Company B seems to be getting paid by customers before they have to pay suppliers, and holds

• a low level of stock.

• The next financial ratio is all about the companiesfinancing strategy: does it primarily

• borrow money to finance operations, or rely on capital provided by the shareholders?

• For company A, 100 in borrowings, 700 in equity, so a debt-to-equity ratio of 1 to 7.

• You could call this a conservative and robust way of financing, with a big buffer of equity

• that helps defend the business continuity of the company in case of future losses.

• For company B, 400 in borrowings, 100 in equity, so a debt-to-equity ratio of 4 to 1.

• For every dollar of shareholder capital (equity), there are four dollars borrowed, which is

• possibly more fragile.

• A related financial ratio is equity as percentage of the balance sheet total.

• 70% for company A, 12.5% for company B. Based on the debt-to-equity ratio, and equity as

• percentage of total, you could say that company A has a low leverage, while company B has

• a high leverage.

• Part 3: financial ratios that combine information

• from the income statement and the balance sheet.

• This is where you might see new storylines and connections, on top of what you discovered

• in analyzing the income statement individually and the balance sheet individually.

• Let’s start with a “big picturefinancial ratio called Return On Equity, which is Net

• Income divided by Equity.

• For company A, 160 divided by 700, which is 22.9%.

• For company B, 80 divided by 100, which is 80%.

• On the Return On Equity metric, company B far outperforms company A.

• What is driving that?

• While company A has higher profit margins (as we saw in the income statement analysis),

• company B has a much higher financial leverage (as we saw in the balance sheet analysis).

• There is a third component to the Return OnEquity calculation:

• the financial ratio called asset turnover.

• Asset turnover looks at how much revenue is generated by the company

• with the assets it has.

• For company A, asset turnover is 1.

• 1000 in assets on the balance sheet generates 1000 in revenue in the income statement.

• For company B, asset turnover is 1.25.

• Let’s dig a little deeper into two key subsets of this asset turnover ratio.

• The first one is receivables turnover: the number of times per year that a business collects

• its average accounts receivable, the ratio between revenue in the income statement and

• accounts receivable on the balance sheet.

• 6.67 for company A, 20 for company B. Receivables turnover might be a bit abstract for a lot

• of people, so let’s turn it into a more tangible related metric called Days Sales

• Outstanding: how many days does a company need to wait before a customer pays.

• 55 days for company A, and just 18 days for company B.

• The second subset of the asset turnover ratio is inventory turnover:

• the number of times per year that a business turns

• its inventory, the ratio between revenue in the income statement

• and inventory on the balance sheet.

• 5 inventory turns for company A, 10 inventory turns for company B.

• So what do financial ratios tell us?

• Can we say, based on calculating these financial ratios that company A is in better financial

• shape, or company B is in better financial shape?

• Not necessarily.

• Financial ratios do provide us with clear information about the financial footprint

• of a company, and deepen your understanding of the strategic and operational story behind

• the financial numbers.

• In this video on financial ratio analysis, we covered ten financial ratios:

• On the income statement: gross profit %, operating margin %, return on sales %

• On the balance sheet: current ratio, debt-to-equity, equity as % of total

• When linking the P&L and the balance sheet: return on equity, asset turnover, receivables

• turnover, inventory turnover Financial ratio analysis is as much an art

• as it is a science!

• Then subscribe to the Finance Storyteller YouTube channel!

• Thank you.

How does financial ratio analysis work?

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# Financial ratio analysis

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林宜悉 posted on 2020/03/04
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