Hello, this is Bob Salvin, the host of the AIChE e-learning course "Economic Evaluation for
Chemical Engineers". In this series of short videos we are taking a look at financial statements.
This is Part 4 of that series, on Ratios.
Financial statements are the reports that a company issues on a quarterly and year-end
basis to review its financial performance. There are three major reporting statements:
the balance sheet, which looks at a summary of the assets, liabilities, and stockholders' equity for
that company at the end of the reporting period; the Income statement or profit and loss statement,
which generates the net income and EPS numbers (or earnings per share) that occurred
over that time period; and finally the cash flow statement, which looks at the sources and uses
of cash and a change in the cash balance from one period to another. All of these reports must
adhere to an accounting system known as GAPP, Generally Accepted Accounting Principles,
which ensures that these reports are consistent on a period to period basis, and among all companies.
Many meaningful ratios can be generated from these financial statements.
As you know, a ratio is a comparison of two results, dividing one by the other.
These ratios represent a way for assessing various aspects of a company's financial performance.
There are profitability ratios, liquidity and financial health ratios, and finally, efficiency ratios.
When we do ratios, the absolute numbers themselves are not meaningful.
Comparisons are necessary. We can look at the result either over time (for example, year after year),
or we can benchmark the results against other companies and/or industry segments.
Keep in mind that the underlying activity that the ratio represents helps to determine the nature of the result,
that is, whether it's a good result or a bad result, and that ratio analysis does not really provide us
with the answers It just gives us the insights into the performance.
Let's take a look first at some system profitability ratios. The gross margin is simply gross profit
divided by revenue. These numbers, of course, are found on the income statement,
and this percentage really represents how much of the revenue is being kept by the company after
it covers its production costs, or cost of goods sold. Taking that one step further, we can
calculate the operating margin, which looks at operating profit (basically gross profit less any
selling, general and administrative expenses, research and development expenses, and other costs)
and it looks at that as a percentage of revenue.
Return on equity is the next measure, which is net income divided by average stockholders' equity,
which basically looks of the profit is a percentage of the equity that was put in by the stockholders.
And then return on assets, which is basically net income divided by the average total assets,
which looks at the return made on all of the assets of the company.
For liquidity and financial health, I've summarized here four ratios.
The first one is known as the current ratio, which is the current assets of the company divided by
the current liabilities, and these numbers of course all found on the balance sheet.
This really measures the company's ability to pay its short and long-term obligations.
The quick ratio is a similar calculation, but we subtract inventory from the current assets,
and this really reflects the amount of liquid assets that are available to cover the liabilities.
Debt to equity, long-term debt divided by stockholders' equity, is the amount of debt
relative to the equity in a company, and is probably more meaningful to look at over a period of time,
not just a single snapshot. Financial leverage is the total assets to equity, which is just another
measure of reflecting how much debt the company has on its balance sheet.
From an efficiency standpoint, one key measure is days receivable outstanding.
The calculation is noted on the chart. It takes the number of days in a year and divides by the
accounts receivable turnover, where the turnover is defined as revenue divided by the
average accounts receivable. These numbers, of course, come from the income and balance sheet.
This will reflect the number of days it takes for the company to collect the money that is owed
to it by its customers, from its sales. Days of inventory is a similar calculation, now using
the inventory turnover numbers, and this reflects a number of days it takes to sell its inventory.
And finally days payable outstanding looks at a similar calculation to see how quickly bills are
being paid by the company. SG&A to revenue is another efficiency number, which looks at
the amount of overhead relative to sales, and this number is really a more meaningful number when
compared to other companies in the company's peer group.
To summarize, ratios are a major way of analyzing the company's financial results from its financial
statements. They are best used on a comparative basis: year-to-year or versus other companies.
If you like to learn more about the underlying financial statements,
the balance sheet, income and cash flow statements, please visit the other videos in this series.
This is Bob Salvin, your host of this video, and hopefully you will join me in those other videos.