1 00:00:00,240 --> 00:00:03,960 In this section, we are going to discuss about financial ratios. 2 00:00:05,880 --> 00:00:13,170 Financial ratios are very commonly used when doing financial analysis, and it is often used to describe 3 00:00:13,170 --> 00:00:21,330 a company's performance and the situation the company is in, which is why when we use financial issues, 4 00:00:21,750 --> 00:00:25,890 we also say that we are doing descriptive analysis of the company. 5 00:00:26,670 --> 00:00:32,640 That is, we cannot use financial ratios to predict how the company will do in the future. 6 00:00:33,210 --> 00:00:41,640 But we can answer questions on how the company performed and the history and what is the situation currently. 7 00:00:42,950 --> 00:00:50,750 This is the reason investors look at financial ratios to understand companies strength, and we also 8 00:00:50,750 --> 00:00:55,850 see these ratios commonly used in company, report investor presentations, etc.. 9 00:00:57,790 --> 00:01:05,830 So in this section, we will briefly cover what all these financial ratios mean, and we will also see 10 00:01:05,830 --> 00:01:08,800 how to calculate them in Excel. 11 00:01:10,900 --> 00:01:19,690 Please note that the list of ratios or how those ratios will be calculated, those are not fixed by 12 00:01:19,690 --> 00:01:21,670 any authority or anybody. 13 00:01:22,910 --> 00:01:30,080 The reason that I'm showing you here and there categorization that formula, all of these are based 14 00:01:30,080 --> 00:01:34,490 on general acceptance, that is the ratio that I will show you. 15 00:01:34,970 --> 00:01:38,780 That formula is generally accepted across all the companies. 16 00:01:40,890 --> 00:01:48,750 However, from book to book or coast to coast, the definition of these ratios, the categorization 17 00:01:48,750 --> 00:01:56,910 may differ, but the concept and understanding will remain the same, and that is what is more important. 18 00:01:59,160 --> 00:02:03,550 So we are categorizing the issues into four different categories. 19 00:02:04,260 --> 00:02:06,300 The first will be profitability ratios. 20 00:02:07,200 --> 00:02:15,000 Second is liquidity ratios towards debt management ratios and important asset management ratios. 21 00:02:16,530 --> 00:02:19,200 So let's begin discussing profitability ritual's. 22 00:02:24,200 --> 00:02:31,670 The first profitability issue we are going to discuss is gross profit margin, this ratio indicates 23 00:02:31,670 --> 00:02:38,300 the percentage of revenue which is available to cover operating costs and other expenses. 24 00:02:40,480 --> 00:02:49,030 The formula is very simple, it is just the ratio of gross profit of the company divided by the total 25 00:02:49,030 --> 00:02:50,650 sales revenue of the company. 26 00:02:53,180 --> 00:03:00,390 Here we calculate gross profit by subtracting cost of goods sold from the total sales. 27 00:03:01,340 --> 00:03:08,300 So we are only removing the input materials cost and we are trying to gauge what percentage of revenue 28 00:03:08,420 --> 00:03:11,360 is available to cover all the other expenses. 29 00:03:12,950 --> 00:03:14,900 Next is net profit margin. 30 00:03:16,660 --> 00:03:23,530 This is simply the ratio of net profit after tax with the total revenue that the business made. 31 00:03:25,810 --> 00:03:33,520 This means that this is the percentage of revenue which the owners can get as a return from the business. 32 00:03:35,410 --> 00:03:43,900 As a general rule, a company with higher net profit margin than its competitors is considered a better 33 00:03:43,900 --> 00:03:46,540 investment opportunity by the investors. 34 00:03:49,370 --> 00:03:51,680 Today's return on assets. 35 00:03:53,560 --> 00:03:59,380 Return on assets measure the return earned by the company on its asset. 36 00:04:01,610 --> 00:04:09,170 The higher this ratio, the more income is generated by a given level of assets employed by the company. 37 00:04:12,040 --> 00:04:16,210 The formula is this net profit plus. 38 00:04:17,140 --> 00:04:21,040 Tax adjusted interest divided by the total assets. 39 00:04:23,310 --> 00:04:29,610 Notice that there is one additional term in the numerator here, which is tax adjusted interest. 40 00:04:31,840 --> 00:04:39,370 We are adding this because when we are calculating our way, we are measuring the return of all the 41 00:04:39,370 --> 00:04:47,530 assets in the company, regardless of whether they were financed by loans or debt or equity or whatever. 42 00:04:50,220 --> 00:04:58,980 For example, suppose a person he sets up a machine worth a hundred dollars using his own money and 43 00:04:59,010 --> 00:05:03,330 earns ten dollars from the product created from that machine. 44 00:05:05,720 --> 00:05:10,130 Then return on asset and the situation is 10 percent. 45 00:05:12,070 --> 00:05:16,660 That is ten dollars divided by hundred dollars, which comes out of it 10 percent. 46 00:05:18,410 --> 00:05:21,530 Now, if person B does the same thing. 47 00:05:22,560 --> 00:05:26,400 But to finance the machine, he takes a loan of hundred dollars. 48 00:05:27,330 --> 00:05:33,420 And at the end of the year, he pays ten dollars as interest amount. 49 00:05:35,970 --> 00:05:43,560 In this case, also will take the return of ten dollars and we will not subtract the interest payment 50 00:05:43,770 --> 00:05:52,830 from it to calculate the net profit, because this asset, even though it was financed by a loan, it 51 00:05:52,830 --> 00:05:55,410 is still giving us a return of ten dollars. 52 00:05:57,340 --> 00:06:01,750 So the return on asset of the same machine will still be the same. 53 00:06:03,760 --> 00:06:06,730 Then the fort ratio is return on equity. 54 00:06:07,760 --> 00:06:12,560 Which measures the return owned by a company on its equity capital. 55 00:06:14,400 --> 00:06:20,970 Return is again, net profit, and the denominator here will be total equity. 56 00:06:21,910 --> 00:06:30,100 Generally higher the ROIC compared to the competitors in the industry, the better investment option 57 00:06:30,100 --> 00:06:31,780 it is for the investors. 58 00:06:36,500 --> 00:06:38,120 Next, our liquidity issues. 59 00:06:39,170 --> 00:06:42,260 Liquidity is basically quickly available money. 60 00:06:43,500 --> 00:06:45,420 It is very important for a company. 61 00:06:46,400 --> 00:06:52,610 If a company has good liquidity, it gives confidence to the lenders that the company will be able to 62 00:06:52,610 --> 00:06:54,170 pay its obligations. 63 00:06:56,920 --> 00:06:58,730 There are three issues that we discuss it. 64 00:06:59,350 --> 00:07:01,150 The first is current racial. 65 00:07:02,820 --> 00:07:10,590 Current ratio is simply the ratio of current assets with current liabilities, that is, we are checking 66 00:07:10,590 --> 00:07:19,770 whether the claims that the company has to pay vs. the amount that will be available with the company 67 00:07:19,770 --> 00:07:20,790 in the current period. 68 00:07:23,670 --> 00:07:32,040 In current assets, we consider all form of cash or any such asset that will be converted to cash during 69 00:07:32,040 --> 00:07:32,990 the current period. 70 00:07:35,600 --> 00:07:38,440 Autocorrelation, let's look at quick racial. 71 00:07:39,370 --> 00:07:42,550 Quickly issue is also known as acid test. 72 00:07:43,670 --> 00:07:46,790 And it is a more stringent test of liquidity. 73 00:07:47,850 --> 00:07:53,730 Because in this ratio, we do not include current assets such as inventory. 74 00:07:55,560 --> 00:08:03,600 We only consider the quake assets such as cash or assets, which can be converted to cash quickly, 75 00:08:03,600 --> 00:08:07,260 such as marketable securities and receivables. 76 00:08:08,640 --> 00:08:15,780 So in quick ratio we take three things in the numerator cash, marketable securities and the receivables. 77 00:08:17,220 --> 00:08:25,710 Denominator remains the same compared to quick ratio, cash ratio is even more stringent here. 78 00:08:25,980 --> 00:08:28,370 We even do not consider the receivables. 79 00:08:29,280 --> 00:08:37,320 So this cash plus marketable securities, these are the most liquid funds available to the company. 80 00:08:37,600 --> 00:08:39,780 And we just compare that. 81 00:08:40,110 --> 00:08:46,700 Will this most liquid fund be available to cover the current liabilities of the company or not? 82 00:08:51,130 --> 00:08:54,130 The next set of ratios are for debt management. 83 00:08:55,130 --> 00:08:59,750 So a company raises funds or capital mainly to raise. 84 00:09:00,700 --> 00:09:07,060 Either people invest in it as equity or the business takes a loan or debt. 85 00:09:08,400 --> 00:09:16,170 The balance between these two models of raising capital is often seen to assess the financial risk in 86 00:09:16,170 --> 00:09:17,310 that particular company. 87 00:09:18,790 --> 00:09:22,720 The first official we have here is debt to capital ratio. 88 00:09:24,980 --> 00:09:30,260 This initial measures, the percentage of companies capital represented by date. 89 00:09:32,060 --> 00:09:37,780 A higher ratio generally means higher leverage and higher financial risk. 90 00:09:39,300 --> 00:09:42,270 Similar to this issue is debt to equity. 91 00:09:43,360 --> 00:09:43,780 We're. 92 00:09:44,800 --> 00:09:50,710 And the denominator, instead of considering debt plus equity, we will consider only equity. 93 00:09:52,820 --> 00:09:59,000 A ratio of one here would indicate equal amount of debt and equity in that company. 94 00:10:01,820 --> 00:10:04,790 The third issue here is interest coverage ratio. 95 00:10:06,340 --> 00:10:14,860 These racial measures, the number of times accompanies bit, that is earnings before interest and taxes. 96 00:10:16,690 --> 00:10:20,590 How many times this value can cover its interest payments? 97 00:10:21,790 --> 00:10:30,950 For example, if a company has a value of a hundred thousand dollars and has to pay interest of ten 98 00:10:31,000 --> 00:10:31,840 thousand dollars. 99 00:10:32,790 --> 00:10:36,990 Each year, then the interest coverage ratio will come out to 10. 100 00:10:38,710 --> 00:10:44,320 Such values of interest coverage ratios indicate stronger solvency. 101 00:10:45,300 --> 00:10:52,080 Which gives greater assurance that the company could service its debt from the operating earnings. 102 00:10:53,110 --> 00:11:00,850 So the lenders will be more confident in giving loans or debt to such companies with stronger interest 103 00:11:00,850 --> 00:11:01,620 coverage ratio. 104 00:11:07,480 --> 00:11:12,280 The last of the issues we look at are asset management ratios. 105 00:11:14,400 --> 00:11:22,440 The first here is as a turnover ratio, which is simply the ratio of total revenue earned by the company 106 00:11:22,950 --> 00:11:25,800 and the net asset employed by the company. 107 00:11:26,460 --> 00:11:32,400 So this is basically giving us the efficiency at which the company is using its assets. 108 00:11:34,310 --> 00:11:42,560 If you compare the same number of asset turnover ratio with the competitors of the company, you can 109 00:11:42,560 --> 00:11:47,900 judge which company is performing more efficiently in the same industry. 110 00:11:49,750 --> 00:11:57,400 When you are comparing industries, a lower ratio can indicate that that particular industry or business 111 00:11:57,670 --> 00:11:59,350 is more capitaland into. 112 00:12:00,540 --> 00:12:08,250 Or a low asset turnover ratio can also suggest that the business is not yet operating at full capacity. 113 00:12:10,380 --> 00:12:13,230 The next issue is inventory turnover ratio. 114 00:12:15,430 --> 00:12:20,650 This ratio measures how many times in a period the inventory sells out. 115 00:12:22,330 --> 00:12:28,260 The formula for this issue is cost of goods sold, divided by average inventory balance. 116 00:12:30,130 --> 00:12:37,810 For example, if you sell goods worth hundred thousand dollars and you maintain an average inventory 117 00:12:37,810 --> 00:12:44,620 balance of 20000 thousand dollars, your inventory is replaced five times. 118 00:12:46,360 --> 00:12:53,530 So if your inventory turnover ratio is high, it means that the inventory is held for shorter periods 119 00:12:53,530 --> 00:12:53,930 of time. 120 00:12:55,210 --> 00:13:02,080 You can also convert this ratio into number of days, so if you have inventory turnover ratio, you 121 00:13:02,080 --> 00:13:07,020 can find out inventory days using the third formula, which is inventory. 122 00:13:07,030 --> 00:13:12,370 This is equal to number of days in a period divided by inventory turnover. 123 00:13:14,130 --> 00:13:22,290 So if our inventory turnover came out to be five, so within one year, our inventory gets down five 124 00:13:22,290 --> 00:13:22,710 times. 125 00:13:24,480 --> 00:13:27,270 Which means that in nearly 72 days. 126 00:13:28,450 --> 00:13:30,910 Our entire inventory is a new. 127 00:13:32,290 --> 00:13:40,330 Generally, we believe that lower the inventory is, the better it is, however, this value varies 128 00:13:40,330 --> 00:13:47,290 from industry to industry, and it is better to compare inventory days between competitors of the same 129 00:13:47,290 --> 00:13:50,410 industry and not from one industry to another industry. 130 00:13:52,010 --> 00:13:59,320 So these are the four categories of issues that we will be now calculating in our Excel sheet. 131 00:14:00,450 --> 00:14:06,840 You can find more such financial issues, depending on the kind of analysis that you are doing, and 132 00:14:06,840 --> 00:14:13,650 there are several ratios created by several orders which are useful for a particular kind of analysis. 133 00:14:14,590 --> 00:14:19,630 You can also create your own ritual for your own analysis and business purposes. 134 00:14:20,730 --> 00:14:28,680 These are generally accepted, ratio's and categorisations, you may find differences in the formulas 135 00:14:28,680 --> 00:14:30,600 and categorization of the issues also. 136 00:14:31,200 --> 00:14:38,040 However, I hope that you get the concept and what are the kind of insight we try to derive from these 137 00:14:38,040 --> 00:14:38,550 ratios? 138 00:14:40,000 --> 00:14:46,150 Now, let us go to Excel and try to calculate these ratios for a set of balance sheets and profit and 139 00:14:46,150 --> 00:14:46,900 loss statement.