## Using Accounting Ratios to Assess Business Performance

congratulations on making it this far

you’ve covered a huge amount you’ve learned about the three main financial

statements the key income statement and balance sheet accounts the core

principles of bookkeeping the double-entry principle the accounting

equation and you know how to work with T accounts and what a debit and credit is

and you’ve also learned about financial statement analysis horizontal and

vertical analysis and much more the next two videos are really the last piece of

the puzzle we’ll be looking at ratio analysis its key goal is to analyze four

main dimensions liquidity solvency profitability and growth these are in

fact the four key topics that need to be addressed when analyzing a given

business liquidity is the firm’s capability to pay its short-term

obligations if we say that a company is liquid this usually means that a

significant portion of its assets are easily convertible in cash meanwhile

solvency indicates a company’s ability to meet its long-term obligations if a

company finances a high portion of its assets with financial debt then it runs

the risk of having financial difficulties due to increasing interest

expenses profitability ratios are important for every company as it has to

produce sufficient profits that will satisfy its employees and owners given

that there can be several drivers that determine whether a company is

profitable it is common practice to break down some of the profitability

ratios into smaller ingredients growth ratios provide insights about the speed

at which a company’s revenues margins profits and assets are growing so these

are the four main dimensions let’s show a few ratios that are used in order to

analyze each of these important dimensions

some of the most common liquidity indicators are the current ratio and the

net trade cycle calculation the current ratio is given by the fraction between

short-term assets and short-term liabilities it allows us to have an idea

about the company’s ability to pay its short-term liabilities the recommended

value for this ratio varies according to the industry in which the company

operates however a ratio above 2 is usually considered good the net trade

cycle shows how many days it takes for a company to convert resources that it

uses in the production of its goods into cash

also known as the cash conversion cycle this calculation measures the amount of

time for which each dollar is tied up in the production and sales process before

it is converted into cash through sales to customers in order to calculate the

net trade cycle we need to calculate DSO d io and dpo calculating the net trade

cycle is easy once we have DSO d io and dpo

it is given by DSO + di o- DP o this calculation would allow us to understand

whether the firm is efficient in its use of capital a peer comparison is always

helpful in such situations the main ratios used to evaluate solvency are the

debt ratio also known as leverage and the interest coverage ratio the debt

ratio shows what portion of a company’s assets is financed with debt in order to

calculate it we need to divide total liabilities into total assets of course

the lower this is the more sustainable the business under consideration

for many industries a value of up to 0.67 is acceptable however you should

always compare the ratio with an industry average and avoid applying it

mechanically when a company’s debt increases it has to pay higher interest

expenses right financial institutions always want to leave a cushion which is

why they often measure the proportion between a company’s operating profits

EBIT and its interest expenses if it is higher than two then this means that the

company will be able to pay its interest expenses and will likely be able to

repay some of the principle to alternatively a ratio below one shows

that a company is unable to repay even its interest expenses and will produce

losses for its shareholders there are many profitability ratios but

we will concentrate on just a few roa means return on assets it is given by

EBIT divided by total assets this is an indicator of the profitability of the

company without considering the way in which its activities were financed our

OE on the other hand stands for return on equity and is given by net income

divided by shareholders equity it shows how much profit was generated by a

company with the money that shareholders invested in its activities the our OE

ratio can be decomposed take a look at the following formula it shows us that

our OE is equal to the following three components ROA the ratio that we saw

before multiplied by total assets over owner’s equity multiplied by net income

over EBIT each of the three components points to a different aspect of the

company’s structure ROA is a measure of profitability that does not consider

financial structure then we have the debt to equity ratio which

is an indicator of the company’s financial structure showing the ratio

between external and own financing and finally the third ratio incorporates the

impact of non operating items financial items taxes extraordinary items on the

company’s profitability finally we have growth ratios examples of these ratios

are change of sales ratio growth in total assets etc we already saw how to

calculate these changes the calculation of revenues growth can be useful because

it helps us understand how fast a company is growing and to compare its

growth with its peers this is one of the crucial aspects that determines how

interesting the business is going to be to investors okay wonderful

we learned more about the various types of ratios and I think that now is the

best time for a practical exercise in our next lesson we’ll calculate each of

these ratios for one of the largest companies in the world P&G