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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?

  • The debt-to-equity ratio can help you put that in perspective.

  • 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!

  • Want to learn more about business, finance and accounting?

  • 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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