00:00:00
Hello i'm James you're watching Accounting
Stuff and today we're covering Financial Ratios
00:00:05
I'll explain what Financial Ratios are
we'll break them down into five main
00:00:10
groups and then I'll show you how to work out 25
Financial Ratios in 25 minutes ambitiousI know
00:00:18
but we've got this! Before we get started I want
to say a big thanks to all my channel members your
00:00:24
support is always appreciated thank you. Financial
statements! Financial Ratio Analysis begins with
00:00:33
Financial Statements accounting reports that
summarize the financial activities and performance
00:00:40
of a business. The three main financial statements
are the Income Statement, the Balance Sheet and the
00:00:47
Cash Flow Statement. However, we can work out most
Financial Ratios using only the Income Statement
00:00:55
and the Balance Sheet. The Income Statement looks
like this. It gives us a summary of a business's
00:01:01
revenues and expenses over a period of time and
then we have the Balance Sheet which gives us
00:01:08
a snapshot of a business's assets, liabilities and
equity at a point in time. So what is Financial
00:01:18
Ratio Analysis? Good question. A ratio tells
us how much of one thing we have compared to
00:01:25
another thing. In a Financial Ratio we compare
the size of one line in a financial statement
00:01:31
against another. Usually we can find these line
items in the Income Statement or the Balance Sheet
00:01:38
and most of the time Financial Ratios are shown as
percentages. Whenever that's the case we multiply
00:01:45
by 100. Financial Ratio Analysis is the process of
comparing different Financial Ratios over time and
00:01:54
across different businesses. What types of
Financial Ratio are there? I like to break
00:02:00
them down into five main groups: Profitability
Ratios, Liquidity Ratios, Efficiency Ratios,
00:02:09
Leverage Ratios and Price Ratios. Now I'll show you
how to work out 25 of the most popular Financial
00:02:16
Ratios that live in each of these groups. If
you want to make some notes then now might
00:02:22
be a good time to grab yourself a pen and paper,
or if you'd like to stay focused on this video
00:02:27
I've made some Financial Ratios Cheat Sheets
that summarize pretty much everything I'm
00:02:32
about to cover. You can find them on my website the
link is down in the description and the proceeds
00:02:37
help support this channel. We'll kick things off
with Profitability Ratios. Profitability Ratios
00:02:44
measure how efficiently a business generates
profit from four different things: revenue,
00:02:50
assets, equity and capital employed. We can break
them down into Margin Ratios and Return Ratios
00:02:59
Margin Ratios measure how well a business converts
revenue into profit. We can calculate Margin Ratios
00:03:06
using one simple formula: Profit Margin is equal
to profit divided by revenue. Profit and revenue
00:03:14
live in the Income Statement. Revenue is on
the top line. It's the earnings that a business
00:03:21
generates over a period of time and profit
is the financial gain left in the business
00:03:28
after deducting expenses. As you can see there
are three types of profit in an Income Statement:
00:03:35
Gross Profit, Operating Profit and Net Profit.
Gross Profit is the big one at the top. It's
00:03:43
a business's revenue minus its cost of sales and
if we take gross profit and divide it by revenue
00:03:51
then we can find a business's Gross Profit Margin
which is the first of our 25 Financial Ratios
00:03:59
Gross Profit Margin tells us how much
big profit a business is able to generate
00:04:04
from each dollar of revenue earned. It's a
similar story with the other Margin Ratios
00:04:11
if we move further down the Income Statement and
subtract operating expenses as well then we get to
00:04:17
operating profit. Operating profit divided by
revenue gives us our second Financial Ratio
00:04:25
Operating Profit Margin and if we head down
to the bottom line of the Income Statement
00:04:31
we have net profit. This is the residual profit
that's left over after deducting all of the
00:04:38
businesses expenses and net profit divided by
revenue is you guessed it! Net Profit Margin
00:04:46
our third margin ratio. If you'd like to learn
about these in a bit more depth i've made videos
00:04:52
covering each of these ratios. I plan to do the
same for the rest of the Financial Ratios in this
00:04:57
playlist so don't forget to subscribe if you'd
like to watch those. But what about Return Ratios?
00:05:05
Return Ratios work in a similar way. But this time
we have net profit on the top of the equation.
00:05:12
As we saw a moment ago net profit can be found
on the bottom line of an Income Statement
00:05:18
in a Return Ratio we measure how much net profit
a business is able to generate relative to
00:05:24
its assets, equity or capital employed. We can
find all three of these in the Balance Sheet
00:05:32
assets make up the left-hand side of a Balance
Sheet. Total assets represent all of the stuff
00:05:38
that a business owns at a point in time. If we take
a business's net profit from the Income Statement
00:05:46
and divide it by total assets from the Balance
Sheet then we've calculated its Return on
00:05:53
Assets or 'ROA'. Hold up i want to point out
one thing. When we compare a line item from
00:06:00
the Income Statement against a line item
from the Balance Sheet like we have here
00:06:04
it's a good idea to use the average Balance
Sheet number. This is because the Balance
00:06:09
Sheet is a snapshot at a point in time whereas
the Income Statement covers a period of time
00:06:15
if we average the opening and closing Balance
Sheet numbers then we can compare like with like
00:06:22
I won't mention this every time it comes up but
please keep it in mind. On the right hand side of
00:06:27
the Balance Sheet we have liabilities and equity.
Together these represent the stuff that a business
00:06:35
owes. A business owes liabilities to third parties
and it owes equity back to its owners. Total equity
00:06:44
is the owners or shareholders claim on the net
assets of the business and Return on Equity or 'ROE'
00:06:53
is equal to a business's net profit divided by
it's total equity. Return on Equity shows us how
00:07:01
efficiently a business uses its owner's money to
generate bottom line profit. But there's a problem
00:07:10
some businesses choose to take out very
large loans to fund their operations
00:07:15
this reduces the owner's claim on net
assets and it can inflate Return on Equity
00:07:22
in these situations it can be better to use
capital employed. Capital employed is a business's
00:07:28
total asset minus its current liabilities. It
ignores all long-term debt used to fund operations
00:07:37
net profit divided by capital employed is
Return on Capital Employed or R-O-C-E. 'ROCE'
00:07:48
'ROCE' can even go a step further and use
operating profit instead of net profit. So Return
00:07:56
on Capital Employed is equal to a business's
earnings before interest and tax divided by
00:08:03
its capital employed. At number six this is our
last Return Ratio and our last Profitability Ratio
00:08:11
let's move on to Liquidity Ratios. Liquidity
Ratios measure how well a business can cover
00:08:18
its short-term debt obligations using different
assets. the calculation looks something like this...
00:08:26
a Liquidity Ratio is equal to some assets divided
by current liabilities. These assets on the top
00:08:34
are used to cover a business's short term debt
obligations on the bottom. Everything you see
00:08:40
here can be found on the Balance Sheet which makes
things nice and simple. Current liabilities can be
00:08:46
found on the right hand side of a Balance Sheet
they are a businesses obligations that need to be
00:08:52
settled within one year. On the left we have assets.
Liquid assets are the stuff that a business owns
00:09:01
that can be converted into cash quickly and
easily. The most liquid asset of them all
00:09:08
is cash itself. If we take cash and divide it
by current liabilities then we have the Cash
00:09:15
Ratio. If the Cash Ratio is bigger than one then
a business is able to pay off all its short-term
00:09:22
debt obligations with the cash that it has on
hand. This is an indicator of good financial
00:09:29
health. But it isn't always possible. Sometimes
we need to look at all of the business's liquid
00:09:36
assets on the Balance Sheet. So that means cash,
marketable securities like short-term investments
00:09:42
and accounts receivable. Inventory and prepaid
expenses aren't considered to be liquid assets
00:09:50
we can find the Quick Ratio by taking all liquid
assets and dividing them by current liabilities
00:09:58
this checks if a business can cover
its short-term debt obligations using
00:10:02
everything that can quickly be converted
into cash. But we can go a step further too
00:10:09
we can consider all of a business's current
assets including inventory and prepaid expenses
00:10:17
that gives us the Current Ratio... current assets
divided by current liabilities. This is our ninth
00:10:25
Financial Ratio and the last of our Liquidity
Ratios. Now let's move on to Efficiency Ratios.
00:10:34
Efficiency Ratios measure how effective a business
is at selling inventory to customers, how quickly
00:10:40
it's able to collect cash back from them and how
reliably it pays off its creditors. There are two
00:10:48
parts to this. We have Turnover Ratios and we have
the Cash Conversion Cycle. Turnover Ratios measure
00:10:55
how quickly a business conducts its operations.
They compare one line from the Income Statement
00:11:01
against a related line in the Balance Sheet.
take the Inventory Turnover Ratio for example
00:11:08
in this one we divide cost of goods sold in the
Income Statement by inventory in the Balance Sheet
00:11:16
the Inventory Turnover Ratio tells us how many
times a business has sold and replenished it's
00:11:23
inventory over a period of time. Rhe Receivables
Turnover Ratio works in a similar way. This time
00:11:31
we divide revenue in the Income Statement
by accounts receivable in the Balance Sheet
00:11:37
this one measures how efficiently a business
collects cash from its customers. If we instead
00:11:45
divide revenue by total assets from the Balance
Sheet then we also have the Asset Turnover Ratio
00:11:53
this one may feel familiar because it's not too
different to Return on Assets which we covered in
00:11:58
Profitability Ratios. That was net profit divided
by total assets. In this one however, the Asset
00:12:06
Turnover Ratio ignores expenses and focuses on
revenue and how efficiently a business generates
00:12:14
revenue using the stuff it owns. Then we have the
Payables Turnover Ratio which is cost of goods
00:12:22
sold from the Income Statement divided by accounts
payable in the Balance Sheet. The Payables Turnover
00:12:29
Ratio shows us how reliably a business pays off
its suppliers. It's our last Turnover Ratio. Onward
00:12:39
to the Cash Conversion Cycle. The Cash Conversion
Cycle tells us the average number of days a
00:12:45
business needs to convert it's investments
in inventory into cash. It works like this...
00:12:52
the Cash Conversion Cycle is equal to Days
Sales of Inventory plus Days Sales Outstanding
00:13:00
plus Days Payable Outstanding. These three Cash
Conversion Ratios are the upside down of Turnover
00:13:08
Ratios. Days Sales of Inventory is the upside
down version of the Inventory Turnover Ratio
00:13:15
this time we have inventory from the Balance
Sheet on the top and cost of goods sold from
00:13:21
the Income Statement on the bottom. But this
time round we multiply the ratio by 365
00:13:29
the number of days in a year. When we do
this we get the average number of days
00:13:35
it takes a business to convert its inventory into
sales. Also known as the Inventory Turnover Period.
00:13:44
Days Sales Outstanding is the inverse of the
Receivables Turnover Ratio. It's accounts receivable
00:13:50
from the Balance Sheet divided by revenue from
the Income Statement. When we multiply it by 365
00:13:58
it tells us the Receivables Collection Period
the average time it takes a business to collect
00:14:04
a payment from a sale in days. And last but not
least we have Days Payable Outstanding which is
00:14:13
basically the Payables Turnover Ratio upside down.
Days Payable Outstanding is accounts payable from
00:14:21
the Balance Sheet divided by cost of goods sold
from the Income Statement times 365. It's the
00:14:30
average Payables Payment Period. The number of days
it takes a business to pay its bills. Days Payable
00:14:37
Outstanding is our 16th Financial Ratio and closes
the loop on the Cash Conversion Cycle. How long it
00:14:46
takes a business to turn over inventory, collect
cash on sales and pay bills. Leverage Ratios!
00:14:55
leverage is when you up your risk by taking
on debt in order to maximize your return or
00:15:02
reward. Leverage ratios can be split out into
two categories: Balance Sheet Ratios and Income
00:15:10
Statement Ratios. Leverage Ratios in the Balance
Sheet divide total liabilities by total assets
00:15:17
or total equity. If we take total liabilities and
divide them by total assets then voila! We have the
00:15:27
Debt to Assets ratio the 'DTA' ratio. This tells us
how much of a business's assets have been financed
00:15:36
using debt. This ratio considers both short and
long term debt obligations. If we jump back to
00:15:45
total liabilities in the Balance Sheet and divide
them this time by total equity then we've got the
00:15:51
Debt to Equity Ratio 'DTE'. This tells us how much
debt a business has for each dollar of equity
00:16:00
a business can finance its assets by the borrowing
money from third parties or using its owner's own
00:16:08
money. Raising debt can be helpful since it uses
leverage to expand a business but it comes with
00:16:16
some risk in the form of interest. Which leads us
nicely into Interest Ratios which we can find in
00:16:24
the Income Statement. These determine a business's
ability to meet its financial obligations. We
00:16:32
take a type of profit and divide it by a type of
interest. Both can be found in the Income Statement
00:16:40
the Interest Coverage Ratio compares a business's
operating profit against its interest expenses
00:16:47
operating profit is calculated
before interest so this tells us
00:16:52
whether a business has earned enough profit
to cover the interest on its debt obligations
00:16:59
but being able to cover interest isn't the whole
story. Total Debt Service is made up of interest
00:17:07
and repayments of the principal. The
current portion of long-term debt
00:17:13
so it's also worth checking the Debt Service
Coverage Ratio which is equal to 'EBITDA'
00:17:20
divided by Total Debt Service. 'EBITDA' is earnings
before interest, tax, depreciation and amortization
00:17:31
this ratio uses 'EBITDA' instead of operating profit
because it excludes depreciation and amortization
00:17:40
which are both non-cash expenses. It tells us
whether a business generates enough profit to
00:17:47
service both the interest and principal repayments
on its debt and that's a wrap on Leverage Ratios
00:17:56
But don't go anywhere just yet, we have one last
group to cover. Price Ratios. Price Ratios are very
00:18:04
important. Investors use them in Financial
Analysis to evaluate the share price of a
00:18:10
business and determine if it's a worthwhile
investment. Price Ratios tend to fall
00:18:16
into two groups. We have earnings-based ratios
and dividend-based ratios. We'll start with
00:18:25
earnings-based ratios. You've probably
heard of this one... Earnings per Share or 'EPS'
00:18:32
it's a business's net profit divided by the number
of common shares outstanding. Earnings per Share
00:18:40
represents the slice of a business's profit
that's allocated to each share of common stock
00:18:47
the number of common shares outstanding
can be found in the equity section of a
00:18:52
business's Balance Sheet either in the note for
common stock or in the line item description
00:18:59
and as we've seen net profit can be found on the
bottom line of the Income Statement. Sometimes the
00:19:06
'EPS' calculation is net profit minus preferred
dividends divided by common shares outstanding
00:19:14
this is because dividends are distributed to
preferred shareholders before common shareholders
00:19:21
Earnings per Share is a useful way to measure
profitability, but it doesn't give us the whole
00:19:27
picture. If we take a business's share price
and divide it by it's Earnings per Share
00:19:33
then we find its Price-to-Earnings Ratio also
known as the 'P/E Ratio'. A business's share
00:19:41
price can be found quickly online. It's the lowest
amount you can buy one unit of company stock for
00:19:48
in a publicly traded company that's listed
on a stock exchange, share prices fluctuate
00:19:54
constantly and are determined by the market. The
P/E Ratio is share price divided by Earnings per
00:20:02
Share so it tells us how much the market is
prepared to pay for each dollar of earnings
00:20:09
share prices can be overvalued which can lead to
a large Price-to-Earnings Ratio however a high
00:20:16
P/E Ratio could indicate strong future growth.
Which brings me on to the next Financial Ratio...
00:20:24
the Price-to-Earnings-to-Growth or 'PEG Ratio'.
This is equal to the Price-to-Earnings Ratio
00:20:32
which we just covered divided by the
expected Earnings per Share Growth
00:20:38
'EPS Growth' is an estimate and represents the
projected annual growth rate in Earnings per Share
00:20:46
so the PEG Ratio delves a little deeper
into determining an investment's value
00:20:51
than the P/E Ratio. In theory it tells us if a
company's stock is overvalued, undervalued or
00:20:58
priced correctly given the expected future growth
rate. I say 'in theory' because the validity of
00:21:05
the PEG Ratio is completely dependent on the EPS
Growth Rate which like I mentioned is an estimate.
00:21:13
Moving on, moving on. What about dividend-based
ratios? Dividends per Share is calculated in
00:21:21
a very similar way to Earnings per Share. But
this time we swap out net profit on the top for
00:21:27
dividends paid so 'DPS' is equal to dividends paid
divided by the number of common shares outstanding
00:21:37
dividends are cash distributions paid out to the
shareholders of a business over a period of time
00:21:44
this makes Dividends per Share an important ratio
because dividends are effectively income from
00:21:51
an investor's point of view. If a business pays
out a special dividend which is a non-recurring
00:21:58
extra dividend related to a particular event
then we should deduct it when working out
00:22:04
Dividends per Share. Another handy formula for
investors is the Dividend Yield Ratio. In this
00:22:11
one we take Dividends per Share and divide it by
the share price of the company. This represents the
00:22:18
percentage of a business's share price that
it tends to pay out in dividends each year
00:22:24
and that's our 25th Financial Ratio! However since
you've made it this far I do have one extra bonus
00:22:31
one for you. It's called the Dividend Payout Ratio
and we calculate it by taking dividends paid
00:22:38
and dividing it by the net profit earned over the
same period of time. This represents the percentage
00:22:45
of a business's net profit that's distributed back
to the shareholders as a dividend. Another useful
00:22:53
ratio for investors and at number 26 this is our
last Price Ratio which completes our mind map of
00:23:03
Financial Ratios. We covered Profitability Ratios
which measure how efficiently a business generates
00:23:09
profit. Liquidity Ratios which tell us if a
business can cover its short-term debt obligations
00:23:16
Efficiency Ratios which show us how quick they
are at selling inventory, collecting cash and
00:23:22
paying off creditors and then there was Leverage
Ratios which measure how much debt a business has
00:23:28
taken on and its ability to service that debt.
And finally, Price Ratios are used by investors
00:23:36
to evaluate the share price of a business to see
if it's a worthwhile investment. OMG that was a lot
00:23:44
to take in. I've summarized all this information in
my Financial Ratios Cheat Sheets. If you think they
00:23:50
could come in handy then you can find them on
my website and I will see you in the next video.
