Session 6: Financial Ratios

Summary

This transcript delves into the importance and intricacies of accounting ratios in evaluating a company’s financial health. It explores various key ratios, including profit margins (contribution, gross, operating, EBITDA, and net margins), accounting returns (return on equity and invested capital), efficiency ratios, financial leverage, and liquidity ratios. The script emphasizes the significance of scaling financial metrics for cross-company or time comparisons and discusses how different types of debt and capital can affect these ratios. It highlights the practical application of these ratios in corporate finance and valuation, offering insights into a company’s profitability, efficiency, debt management, and risk exposure.

Takeaways

• 😀 Ratios help compare companies of different sizes and scales by normalizing values like profit, making them more meaningful across time or industry.
• 😀 Profit margins are calculated by scaling profits (numerator) to revenues (denominator), and different types of margins can reveal different aspects of a company's profitability.
• 😀 Contribution margin is the profit after variable costs, while gross margin includes all costs of goods sold. Operating margin subtracts operating expenses, and net margin considers taxes and interest.
• 😀 EBITDA margin measures cash profits generated by a business and is often used to assess borrowing capacity, especially for capital-intensive businesses.
• 😀 A difference between operating and net margin can indicate the effect of a company’s debt. High debt can decrease net margin due to interest expenses.
• 😀 In a company's life cycle, you can expect high gross margins but negative operating and net margins in the early stages, with improvements as the company matures and scales.
• 😀 Accounting returns like Return on Equity (ROE) and Return on Invested Capital (ROIC) measure how effectively a company is generating profits relative to the capital invested.
• 😀 ROE focuses on equity investors' returns, while ROIC considers returns to all capital providers (equity and debt), and both measures can vary based on accounting practices.
• 😀 Efficiency ratios like asset turnover and working capital turnover assess how efficiently a company uses its capital to generate revenues, indicating growth potential and reinvestment needs.
• 😀 Debt ratios like debt-to-equity and debt-to-capital assess a company's borrowing level and how much debt it carries relative to equity or total capital.
• 😀 Liquidity and coverage ratios help assess a company's ability to meet its short-term obligations. Interest coverage ratios show the buffer against fixed charges, while liquidity ratios like the current and quick ratios evaluate short-term financial health.

Q & A

Why do we compute accounting ratios?

Accounting ratios are computed to scale financial numbers, such as profits or investments, to a common benchmark, allowing comparisons between companies of different sizes and across time periods. Without scaling, comparing absolute numbers can be misleading, as large companies will naturally have higher profits than smaller companies.

What is the key difference between various types of profit margins like gross margin, operating margin, and net margin?

The key difference lies in what costs are included in the numerator. Gross margin focuses on profits after variable production costs, operating margin includes additional operating expenses like R&D and SG&A, and net margin takes into account all expenses, including taxes and interest payments. Each margin gives insight into different aspects of profitability.

What does a high contribution margin indicate about a business?

A high contribution margin indicates that the company has low variable costs relative to its revenue, meaning a larger portion of each dollar of revenue contributes to covering fixed costs and generating profit. This is common in businesses with scalable models, like software or subscription-based companies.

How does EBITDA margin differ from operating margin, and why is it important?

EBITDA margin focuses on cash profits before interest, taxes, depreciation, and amortization, providing a clearer view of a company's operational cash flow. Operating margin, on the other hand, includes all operating expenses and is often used to assess overall business profitability. EBITDA is particularly important for assessing a company's ability to service debt.

How do operating and net margins reflect a company's financial health?

Operating margin reflects profitability from core operations before interest and taxes, showing how well a company controls its operating expenses. Net margin shows the final profitability after all expenses, including interest and taxes. A significant difference between operating and net margins can indicate a company's level of debt and its impact on profitability.

What is the importance of Return on Invested Capital (ROIC)?

ROIC measures how efficiently a company generates profit from its total invested capital (equity and debt). It is a crucial indicator of how well the company uses its capital to create value for investors and can be compared across companies to assess capital efficiency.

What are efficiency ratios, and how are they calculated?

Efficiency ratios measure how effectively a company uses its capital to generate revenue. Common efficiency ratios include revenue-to-working capital, revenue-to-assets, and revenue-to-invested capital. They highlight how well a company manages its resources and scales its operations to generate growth.

What is financial leverage, and how is it measured using debt ratios?

Financial leverage refers to a company's use of debt to finance its operations. Debt ratios like debt-to-equity and debt-to-capital measure the extent to which a company relies on debt versus equity to fund its activities. These ratios help assess financial risk and the potential burden of debt on profitability.

Why is it important to choose the right debt ratio (e.g., debt-to-equity vs. debt-to-capital)?

Choosing the right debt ratio depends on the specific financial aspect being analyzed. Debt-to-equity ratio compares debt to equity, while debt-to-capital compares debt to the total capital invested in the company. The choice impacts how the company's leverage is perceived and affects decisions related to borrowing capacity and risk tolerance.

What is the difference between liquidity ratios like the current ratio and quick ratio?

The current ratio measures a company's ability to cover short-term liabilities with its current assets, while the quick ratio is a more conservative measure that excludes inventory from current assets, focusing on the most liquid assets. Both ratios assess a company's short-term solvency, but the quick ratio provides a stricter measure of liquidity.

How can debt ratios impact a company's ability to secure future funding?

Debt ratios like debt-to-EBITDA indicate a company's ability to generate cash to service its debt. Companies with lower debt ratios or higher EBITDA margins are seen as less risky, improving their chances of securing funding at favorable terms. High leverage, on the other hand, can signal financial distress, reducing borrowing capacity.