Coming now to what I believe is the most important
section in this reading. Common Ratios used in Financial
Analysis. What we'll do first is identify the different
categories. We can have Activity ratios, which essentially
measure how efficiently a company is performing.
A classic example of activity ratio is revenue divided
by assets. This is also called the asset turnover
ratio. This is showing that per unit of assets how
much revenue is a company generating. There are several other
activity ratios which you will see on the next slide.
Liquidity ratios, we have seen before in the reading
on the balance sheet. Solvency ratios, were also discussed
in the balance sheet reading. Profitability ratios,
we saw briefly in the income statement reading. They
tell us about the profitability of a company, examples
would include net income over sales, and here we will
also look at mixed ratios where the numerator comes
from the income statement and the denominator comes
from the balance sheet. Valuation ratios, we will
touch briefly in this reading, but we will see in a
lot more detail later when we study equity and fixed-income.
Essentially, here we are looking at the quantity of an
asset or a flow on a per share basis, a classic example
would be EPS, or we might also have ratios, such as
Price-to-Earnings ratios. In earlier readings, we generally focused on single
statement ratios. So, we had ratios from the income
statement, such as the gross profit margin, operating
margin, or net profit margin, then from the balance
sheet we had liquidity ratios, and solvency ratios
and with the cash flow statement we had ratio that took
a numerator and a denominator from the cash flow
statement. Now, we will spend a lot of time on mixed
ratios where the numerator comes from the income
statement and the denominator from the balance
sheet. The numerator could also come from the cash
flow statement. As a general point, you need
to be careful about how you interpret ratios. The
interpretation should be in the context of the goals
and strategy of the company that you are evaluating,
industry norms, and economic conditions. Let me
elaborate. Consider two companies, Intel and AMD, they are in the same business
both make chips, but they follow different strategies.
Intel is a market leader, it tries to come up with new
and innovative products. Whereas AMD is a follow up, AMD
essentially tries to copy what Intel is doing, that is
putting it very simplistically. Clearly, even though the two company's are in the same industry,
but they follow different strategies. So, chances are that
their ratios will be different. Clearly, the R&D
expenditure for Intel will be much more than the
R&D expenditure for AMD, which might imply that overall
the asset, assuming that R&D's eventually capitalized,
the assets for Intel might be higher, relatively
speaking. Without getting into the details, the
point is that, these different strategies impact
ratios, so when we compare the two companies, we
need to be aware that the goals and strategies are slightly
different. Industry norms is a very important point.
Clearly, a ratio is good or bad depending on how that
ratio is relative to the standard in the industry.
The current ratio, in a given industry, might be 1
on average, whereas in another industry the current
ratio might be 0.3. So, when you are coming up with the
ratio for a company it needs to be looked at in the
context of the industry. Economic conditions
means that the ratio you come up with should be considered
with respect to the current state of the economy.
If the economy is in a recession, then in general net income
and operating income will be low. So, profitability
ratios are likely to be low. On the other hand, if the
economy is booming, then the profitability ratios
are likely to be high. Let's take a deeper look at
activity ratios. Here are the activity ratios that
you essentially need to learn, and over the next few
slides. I will take you over these ratios and help
you understand what they mean, help you interpret
them, and help you remember them. Let's start with
the first one which is extremely important; the Inventory
Turnover Ratio. The formula is cost of goods sold
divided by average inventory, and the interpretation
of this ratio is that it tells us how many times per period
was the entire inventory sold. This is a theoretical
number; It's an approximation, but just to let you
understand where this is coming from think of it
this way. Let's say that over a period the COGS for
a company was 200, and during the same period on average
the inventory was equal to 10. The inventory turnover
ratio then is 200 over 10 which is 20. So, what is the interpretation
of 20? This is approximately the number of times
per period, so this period, that the entire inventory was sold. Now,
a few more remarks about this ratio. Notice that
the income statement item is in the numerator and
the balance sheet item is in the denominator. We
also use average inventory, the point is that if at
the end of the year, it just turns out that the inventory
number is very high, because the company is building
up for the next year, but in general during the year,
the inventory was maintained at 10, then clearly
it makes sense to use 10 as your denominator, and not
25. As a financial analyst however, you might
not know the exact average inventory. So, what you
would normally do is, use the average of the beginning period
inventory, which you can get through the financial
statements and the ending period inventory. The principal
though is that you should, ideally use the average.
If you don't have those numbers you just have the
end of period number then, that's what you use hoping
that the end of period number is indicative of
the average inventory, during the year. If you have
access to quarterly reports, and you have inventory
numbers for the end of every quarter that is very
good, because then you can get a more accurate average
inventory number by using all the end of quarter numbers.
This should be obvious, but I will state it anyway.
A higher number for the inventory turnover ratio
shows greater efficiency. If you have another company
that manages to have a lower inventory balance with
the same cost of goods sold that means it is managing
its inventory better and it might have a higher turnover
ratio such as 25. You also need to understand this
item, days of inventory on hand. This is calculated
by taking the number of days in a period. So, if we are taking
a 1-year period, then we have 365 days in a period divided by the inventory
turnover ratio. In our simple example, if we have 365
divided by 20, then the days of inventory on hand is 18.25. This
is a measure of, on average, how many days of inventory
do we maintain. Obviously, if the activity ratio
is higher than that means that on average we maintain
a lower amount of inventory. Receivables turnover
ratio. This is the revenue divided by average receivables,
and this measures how quickly a company collects
cash. Generally, it would be more appropriate to use credit sales divided by average receivables
rather than revenue, but often credit sales numbers
are not available. Therefore, analysts tend to use the revenue
number. A higher number for this ratio shows greater
efficiency. We also need to calculate the days of
sales outstanding. This again, is the number of days in a period,
if we are considering a year, then
we have 365 days divided by the receivables turnover ratio.
If this number is large, that means that it takes
us a long time to collect our receivables. Payables Turnover
Ratio. This is purchases divided by average trade payables,
and the interpretation is the number of times per
year that a company pays its supplier. As an analyst,
you might not have access to the purchases account,
then what you use is the cost of goods sold plus change
in inventory. If you have a given period, where COGS is equal
to 200, the inventory at the start of the year was 10,
and at the end of the year is 30, then this means that
the purchases must have been 200 plus the change
which is 20. So, purchases must have been 220. So,
that is the precise measure to use. At times an analyst
might simply use purchases as approximately equal
to COGS. In terms of interpreting the numbers, a
relatively high number for the payables turnover
ratio would mean that a company is not making good
use of credit facilities. A very low ratio might indicate
possible liquidity problems. The working capital
turnover ratio is, revenue divided by average working
capital. This tells us how efficiently a company
generates revenue from its working capital, and
just to remind you, working capital is equal to your
current assets minus current liabilities. At times,
if the current assets and current liabilities are
roughly the same, then this number would be approximately
0 and the ratio would be meaningless. We can also
look at the fixed assets turnover ratio and the total
assets turnover ratio. The total asset turnover
ratio is revenue divided by average total assets,
and this tells us how efficiently a company generates
revenue from total assets. So we have looked at several
ratios, and you might be wondering how you can remember
them. I'll give you a very simple technique that
will make it easy for you. The first point is, that
the name tells you the balance sheet item, notice
that in all these ratios you have income statement item
in the numerator and the balance sheet item in the
denominator. With the receivables turnover ratio,
we have average receivables over here, with the total
asset turnover ratio, we have total assets over
here. So clearly, you know the balance sheet item
based on the name. From the balance sheet item, you
can determine the relevant income statement item.
If we have assets in the denominator, the relevant
item in the numerator is revenue. If we have inventory
as your balance sheet item, then the relevant
item would be cost of goods sold. So, based on the balance
sheet item, you can figure out the relevant income
statement item. As I've already mentioned, the income statement is going
to be in the numerator for our activity ratios, and then
also notice that, in general, with the balance sheet
item we use an average value. If you can remember
these four points, then that will allow you to remember all the
activity ratios.