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