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