I'm Larry Walther, this is principlesofaccounting.com chapter 16.
This module considers tools for financial statement analysis.
Now, recognize that CPAs and the Securities and
Exchange Commission and so forth provide safe guards
to ensure the integrity of reported financial information.
That's entirely different than suggesting that a particular company might
be a good investment.
In other words, a report that shows that a company has more depth than assets and
is losing money, that can be reported with great integrity and those financial
statements might be filed and accepted with the SEC and audited by a CPA.
That doesn't guarantee that something's a good investment.
So someone needs to look at financial reports when they are considering
loaning money or making an investment with a company.
They need to look at financial statements very carefully and
see what information is communicated.
And throughout the textbook,
you've seen a number of ratios that have been illustrated.
I tried to integrate each of the ratios that are that are typical
into the textbook, through the textbook as those subjects made sense.
The ratios are key metrics or
key indicators that can be used to summarize financial position, performance,
and so forth, and use that for a comparative basis with other companies.
What I wish to do next is review the ratios that you've
been exposed to in your studies to this point.
Ratios can be divided into certain types or categories of ratio.
I've identified two liquidity ratios.
Liquidity, or a company's cash or near to cash position,
its ability to meet obligations as they come due.
In Chapter 4,
we saw the current ratio, which is current assets divided by current liabilities.
On the far right are some calculations of the current ratio for Emerson Corporation.
In the textbook, the financial statements for Emerson Corporation are presented.
You might want to open up, or look alongside in your textbook and
see if you can find the amount for current assets, current liabilities,
to come up with that ratio.
You can pause the video if you need to.
Another ratio is the quick ratio, it's a measure of liquidity also.
It's even tied to a more stringent definition of liquidity, though.
Rather than looking at total current assets, it looks at the current assets
that are very near to cash, which include cash, short term receivables and
account receivables divided by the current liabilities.
And there again is the value for Emerson Corporation.
It appears in both cases that Emerson's Corporation liquidity, as expressed
through the current ratio and the quick ratio are both in pretty good shape.
Another family of category of ratios are the debt service ratios.
We have debt to total assets that was introduced in Chapter 13.
It's the percentage of assets that are financed by long term and
short term debt, total debt divided by total assets.
A similar ratio, debt to total equity,
where we divide total debt by total equity.
Times interest earned was also introduced in Chapter 13.
It is the amount of income before taxes and
interest divided by the interest charges.
Now, you might look at other textbooks and finance books,
you'll find this ratio calculated several different ways.
But in the main, what it's an attempt to do is show how many times you have money
available to cover your fixed interest obligation
before you would run into financial stress.
Emerson's apparently doing pretty good.
$1.4 million in income before taxes and interest.
Their interest expense or interest charges are $100,000 for the period.
So they've got their interest covered at least 14 times.
Turnover ratios is another category.
In Chapter 7 we introduced accounts receivable turnover ratio.
It measures the frequency of the collection cycle.
It's used to monitor credit policies.
It's net credit sales divided by average net accounts receivable.
And then from Chapter 8, we introduced the inventory turnover ratio,
which is the cost of goods sold divided by the average inventory.
If these ratios are changing for a particular business, it can be indications
of building credit risk, companies not collecting their receivables, or building
their inventory, they're not turning their inventory on a consistent basis.
So it's important to monitor those particular turnover ratios.
We've got certain profitability ratios,
net profit on sales is introduced in Chapter 5.
It's net income divided by net sales, often used for
comparing one business to another, companies in the same industry.
You would probably expect them to have similar profit rates, but
that's not always the case.
Gross profit margin is gross profit divided by net sales.
Of course it compares that intermediate income number before considering all of
your operating expenses.
Return on assets is the net income plus the interest expense,
it's how much is being made before interest divided by the average assets.
So this company's generating a 28% return on its invested average assets.
And return on equity is somewhat similar.
We do need to subtract preferred dividends, so
it's the net income less the portion that needs to be distributed
as preferred dividends divided by the average common equity.
In this, Emerson appears to be doing quite well, with a 48% return on equity.
There's certainly other indicators.
We looked in chapter 15 at earnings per share, which is the income
available to common shareholders divided by the weighted average number of shares.
We looked at the price earnings ratio,
which compares the market price of the stock to the earnings per share.
The dividend yield,
which are the cash dividends divided by the market price per share of the stock.
Dividend payout ratio, which is what proportion of the income is being paid out
in dividends or in other words, dividends divided by earnings.
And then the book value per share in common equity divided by the number of
common shares outstanding.
Beyond just the ratios, the textbook also presents and illustration for
Emerson Corporation using common size financial statements.
This is simply ratios, for example, for 20x5, cash was 17% of total assets,
receivables were 21% of assets, and so it would go.
That's interesting and probably apparent where the numbers come from.
But also important is to monitor year to year.
So, for example, something that jumps out at me in this illustration
is that in 20x5, long term loans were 22% of the total liabilities plus equity,
whereas in the previous year it was 50%.
Notice that equity is now 71% of the organization's financing,
the prior year, 43%.
So it very much quickly, at a glance, tells you how things are ebbing and
flowing within an organization in terms of its overall financial structure.
We could do a similar presentation for a common size income statement.