Learn the toughest concepts covered in your Financial Accounting class with step-by-step video tutorials and practice problems.

14. Financial Statement Analysis

Introduction to Ratios

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a significant part about being able to analyze financial information is to use ratios. Let's go ahead and introduce you to the concept of ratios and see how it relates to accounting. So like I said, it's gonna be a big part of financial analysis here. Right? We're gonna see that companies and investors alike, they're gonna use ratios all the time to make informed decisions. So let's see in accounting, we're gonna be using a bunch of different types of ratios and they're usually gonna fall into one of these five categories. Okay. The first are gonna be liquidity ratios or solvency ratios. Remember that liquidity is how much cash you have and solvency is being able to pay your debts. So do you have enough cash to pay your debts? Your current assets and current liabilities? They're going to deal a lot with that. Okay, so being able to pay your short term obligations. Okay. And then we've got financial leverage this deals more with long term obligations. Okay, this has to deal with long term debt and being able to manage your assets and manage your business to be able to pay off those debts when they come to do so this has to do with long term obligations. And then we're gonna have efficiency ratios. These are our turnover ratios. How are how efficiently are we using different assets, inventory? How efficiently are we using all of our assets are fixed assets. How efficiently are we using our accounts payable our ability to pay um pay our suppliers over time. Okay, so this is how efficiently companies use their assets and sometimes their liabilities we might talk about as well, profitability ratios, Guess what that deals with? Well, it measures how profitable the company is. Right? How how much money are they making? We'll use profitability ratios in that sense. And then finally we've got market value ratios. These deal more with the investor themselves here. We're gonna be using the actual market price of the stock. So when we think about Apple stock, well, there's some book value, some value on the balance sheet for the stock. But that's gonna be significantly different than the open market value of apple stock. Right? Because the book value, remember that's the historical cost. But Apple probably is a lot bigger than it was when it first started. Right. So the market price is gonna be a lot higher there it can be different than the book value. So those market value ratios, they deal with what what kind of investment should I make at this point with the current market price. Right. So in general, when we deal with ratios were always just gonna be dividing one number by another number. Right? And that number in the numerator or the denominator. It could be a group of numbers. It could be an addition or a subtraction. We might have to do a calculation in the numerator, a calculation in the denominator to get to our ratio. Okay. But in general we're just gonna be dividing one number by another number. So ratio, it's just a divided by B just like I've described here and the best way to think about a ratio when you do that division, right. What we're gonna be left with is some sort of decimal. It'll give you like a decimal. It could be like something over 1, 1.34 or like Something below one like .04.08, whatever it is let's say you get in this example 1.54 as I have in in in the example below we'll remember that every number is just divided by one right? Every number can just be divided by one and it's the same number. So what I'm saying here is that for every unit of be right for every unit of the denominator for every one unit of the denominator. Well that means there's 1.54 units of the numerator. So a lot of times when you make a ratio it's not just simply oh calculating the ratio you have to interpret it as well. All right. And a lot of times in your classes, especially this first accounting class they love to give you like a little project on ratio analysis where you have to get a company, you're gonna get their financial statements and you have to calculate all these ratios for that company and do a little bit of analysis. So we're gonna have videos for each day type of ratio that you're gonna come across and how to analyze those ratios and how to deal with them and practice problems on how to calculate them as well. Cool. So this is just a general introduction to ratios here and then we're gonna dive into specific ratios as as you need them in your class. Cool. So remember that when you analyze ratio, it means that for each unit of B for each unit of the denominator, there's going to be 1.54 units of A. Or whatever the right, whatever the ratio gives you, that is how we, how we interpret it. Okay, so let's go ahead and think about how we're going to analyze these ratios. So like I said, we have to analyze these ratios after we calculate them. But how do we analyze them? Well, there's gonna be some ratios that have thresholds, right? There's gonna be some ratio that needs to be above a certain number or else it's a red flag. It's like, hey, something's wrong here. If you don't keep a certain balance in this ratio. Um So there could be a threshold to help us analyze a ratio. Next, we can use what's called benchmarking. We can benchmark against other companies, right? We're going to calculate a ratio for our company and then we'll say, okay, this is the ratio for our company, how our competitors doing or how is the industry average in our industry? What is our ratio compared to those numbers? Right? So we will be able to make better decisions based on how we compare to other companies. And finally we can compare ratios to prior periods, right? We can compare the ratio this year that we calculated to the ratio last year for the same company. Right. Just to notice if there's any trends, any changes in the ratio. That could help give us some information as well. So let's go ahead and do a completely accounting unrelated ratio right here to get us going and thinking about ratios. So let's go ahead and do it julie. A fruit enthusiast eats both apples and oranges this month julie 8 50 oranges and 20 apples express julie's fruit eating habits as a ratio of oranges eaten to apples eaten. And then we've got a little bit for our analysis here, we know that other fruit enthusiasts, so this is maybe competitors in the industry or the industry average other fruit enthusiasts have an orange to apple ratio of 1.5. Cool, so let's go ahead and calculate julie's orange apple ratio. So we're gonna call it the O A ratio. This is julie's oh a ratio. And remember oranges to apples. So we want oranges in our numerator and apples in our denominator. So we're gonna have oranges 50 and apples 20 right, 50 divided by 20. Well that's 2.5. Right? And remember just like I said, our ratio is gonna give us some sort of decimal. Right? It could be something lower than one. Something above one. It can be any number. It could be one as well. So in this case we got 2.5. So what does that mean? How do we interpret this in Julie's fruit eating habits? What this tells us? Remember that we can divide by one here. So what this tells us is that for every one of the denominator and this was apples Right, julie's let me do that. Let me circle those in a different color for every one apple. Well, Julie's gonna eat 2.5 oranges. Right? So this is good information, we know that Julie probably prefers oranges, right? Because she eats a lot more oranges than apples. So this is some good information about Julie's fruit eating habits. But how does she compare to other fruit enthusiasts notice? It tells us that other fruit enthusiasts have a ratio of 1.5. So what does that tell us about other fruit enthusiasts? Well, their ratio being 1.5. If we divide that by the one, right, we just put it over one because any number divided by one is still that number. So that tells us that for every one apple, that other people eat other fruit enthusiasts on average, they're eating 1.5 oranges. Right? So this tells us a little bit more about julie. Right? She probably prefers oranges, even more than other fruit enthusiasts. Right? Because her ratio of oranges to apples is even higher. Cool. So this is a silly example just to introduce you to two ratios and get you thinking about how we do our analysis. Alright, let's go ahead and pause here and we'll move on to our next video.

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