## Mini-Video – Accounting 2 – Ch.17 Fin. Stmt. Analysis – Solvency and Profitability Ratios

-Now let’s talk about solvency ratios, and

these are more for the ability to pay debt in the long term. You’ve got the debt ratio, the equity ratio,

the TIE ratio, the debt-to-equity. These all pretty much measure the same thing

but in different ways. The debt ratio, you compute your total liabilities

as a percentage of your total assets. Now, for a company, is that something that

they should know? For Johnson County families, is that something

they should know? Maybe they can see their debt increasing over

time. You have to pay that debt back eventually,

right? Okay? So there’s different ways to measure that. The TIE ratio takes what we call EBIT, which

is your earnings before interest and taxes have been deducted and divides that by interest

expense. Now all things being equal, do you want your

TIE ratio to be high or low? -High. -Here’s what I always ask. Well, a high ratio would mean a high earnings

and low interest expense. A low TIE ratio would mean low earnings and

high interest expense. So now let me ask the question again. Do we want this ratio to be high or low, all

things being equal? -High. -We want it to be high, we want our numerator

to be high. This is another way of measuring that. And, of course, you could go your debt-to-equity

ratio, as well. All right, quickly let’s talk about ratios

that assess profitability, I know we’re about out of time here, we’ll go a couple minutes

over. We’ve talked about these, as well, even in

this presentation that we’ve done. Gross margin percentage, profit margin, ROA,

return on assets, okay, return on stockholders’ equity. Okay, let’s talk about profit margin. Profit margin is calculated by taking net

income divided by net sales and this just describes how much of each sales dollar actually

is going towards net income, okay? Now, we talked about that a little bit in

some of the previous slides when we were looking at margins. We also talked about gross margin ratio. The gross margin ratio is calculated by taking

the gross margin divided by sales. Now remember gross margin and gross profit

are the same thing. And remember that gross profit, or gross margin,

is calculated by taking net sales minus your cost of goods sold. But this is how much of each sales dollars

is left after deducting cost of goods sold. Remember when we were talking about margin

erosion? These two ratios, gross margin and profit

margin ratios are the ones that we analyze over time. Margin erosion, if these are getting less

over time, that can be a real problem. Along with this is return on assets. Now this book calls this return on assets

but I also want you to be aware that there are some books that call this the ROI, return

on investment. Okay, so if you ever see that term, know that

it’s the same thing. We compute ROA by taking our net income over

our average total assets, okay? And this measures how are we in generating

income from the assets that we have? How are we in generating income from the assets

that we have? Another way of saying it is as written there,

it’s the measure of the overall profitability of those company assets, okay? Now one kind of, we want to maximize this

ratio, we want this ratio to be high, okay? Now another way of looking at the ROA is as

the product of two other ratios. There’s the original ROA ratio but we could

also take a look at the profit margin ratio which we discussed earlier as well as a new

ratio called the total asset turnover ratio. This ratio measures how much sales we are

generating from our assets, okay? So take a look at this, I think this will

clarify it. ROA is also measured by taking profit margin,

this ratio right here, times our total asset turnover, which is right here. And this kind of makes sense if you think

about it and you think about how those ratios are calculated, okay? If profit margin is net income over sales

and total asset turnover is sales over average total assets, we know from grade school when

we multiply fractions that we can kind of cancel those things and thus what is left

is this original formula. Now why do we go through this? Well we go through this because business owners

want to maximize ROA. They can think of this as, we could do that

by increasing our profit margin, the amount of net income that is generated from our sales

and/or we could increase our ROA by improving our total asset turnover, which is the amount

of sales that we’re getting from those assets and the efficiency of that, okay? So that could increase by either increasing

this or this or certainly both. Now there is the total asset turnover which

was introduced in the previous slide. Again, this reflects the company’s ability

to use its assets to generate sales. And then in this section is the return on

common stockholders’ equity. Okay, not the return on assets but the return

on common stockholders’ equity. And we compute this by taking net income minus

your preferred dividends, we want to get that out of there since we’re just concentrating

on common stockholders’ equity divided by your average common stockholders’ equity. This is how well the company is doing in using

the owners’ investments to earn income, all right? Now, with this ratio and with all of the ratios,

I really think it would behoove you to not just use these slides but read through your

chapter, read through the way that your textbook describes these and they give you some examples

in calculating these and what you would include and what you would not include and I think

that will be helpful if you do that before you do your homework or any of the assignments

that I give you in regards to Chapter Seven, or 17, I should say. Okay, a few closing thoughts. Now the limitations of this is you obviously

need to not just concentrate totally on ratios but you need to look at trends in the industry,

maybe there’s some big changes that are happening within the company, maybe the economy is not

doing well, there’s other things you need to take in consideration, as well. One final warning is that you also need to,

when you’re comparing to other companies, they may have different methods of accounting. For example, we might use the LIFO method

where they use the average cost method, so you need to make sure that you’re making meaningful

comparisons.