Top 10 Financial Ratios
Summary
TLDRThis video covers the top ten financial ratios tested on finance and accounting exams. It explains how each ratio is calculated, what it measures, and how to interpret the ratio. Key ratios covered include days sales outstanding, return on assets, return on equity, inventory turnover, debt-to-equity ratio, times interest earned ratio, gross margin, earnings per share, price-to-earnings ratio, and current ratio. Together these ratios assess company liquidity, leverage, efficiency, and profitability from the perspective of management, investors, and creditors.
Takeaways
- 😀 Days Sales Outstanding measures how quickly a company collects payment from customers. Lower ratio means better liquidity.
- 😎 Return on Assets ratio evaluates how efficiently a company uses its assets to generate profits. Higher ratio is better.
- 💰 Return on Equity ratio gauges profits generated from shareholders' investments. Higher ratio signals effective use of capital.
- 📈 Inventory Turnover ratio indicates how fast inventory sells. Higher turnover implies good inventory management.
- 🏦 Debt-to-Equity ratio compares debt financing to equity financing. Higher leverage increases risks and reduces flexibility.
- 💸 Times Interest Earned ratio measures a company's ability to meet debt obligations. Higher ratio indicates more financial security.
- 🤑 Gross Margin ratio shows profitability after deducting production costs. Higher margin allows more flexibility in operations.
- 💲 Earnings per Share indicates net profits attributable to each outstanding share. Useful metric for evaluating investments.
- 📉 P/E ratio compares share price to earnings per share. Higher ratio signals expectations of earnings growth.
- 🚨 Current ratio evaluates short-term liquidity and the ability to pay off short-term liabilities. Higher ratio is better.
Q & A
What does the days sales outstanding ratio measure?
-The days sales outstanding ratio measures the average number of days it takes customers to pay back the business for products or services. It shows how well the company collects payment from customers.
How is return on assets calculated?
-Return on assets is calculated by taking the company's net income and dividing it by the average total assets. It shows how much profit is being generated from the assets invested in the business.
What does a high inventory turnover ratio indicate?
-A high inventory turnover ratio indicates that a company's inventory is being sold quickly and converted into cash efficiently. It shows effective inventory management.
What does the debt to equity ratio assess?
-The debt to equity ratio assesses the degree of financial leverage being used by a company. It shows how much debt is being used to finance operations compared to the amount of shareholder equity invested.
Why is gross margin ratio important?
-The gross margin ratio shows how profitable a company's sales are after accounting for the direct costs associated with production. It assesses how much flexibility a company has to cover operating expenses.
What does earnings per share indicate?
-Earnings per share shows how much net income is earned per outstanding common share stock. It helps investors evaluate profitability on a per share basis.
How can you interpret a company's P/E ratio?
-A high P/E ratio generally indicates investors have strong growth expectations for future earnings. A low P/E suggests poor prospects or slower growth.
What does the current ratio measure?
-The current ratio measures a company's ability to pay off short-term liabilities with its current assets. It evaluates liquidity and the ability to manage debt.
What is a good current ratio number?
-A current ratio of 1.5-3 is considered good. Less than 1 indicates potential trouble meeting obligations, while higher can mean inefficiency.
What are limitations of financial ratios?
-Limitations include variations in accounting methods between companies, use of estimates, and not showing qualitative factors influencing performance.
Outlines
😊 Intro to Top 10 Financial Ratios
The opening paragraph introduces the top 10 financial ratios commonly tested in finance and accounting exams. It mentions the goal is providing help on exam prep from Passing Score Finance and then previews starting with the #10 ratio - Days Sales Outstanding.
👍 #10 Days Sales Outstanding Ratio
Paragraph explains Days Sales Outstanding ratio calculates average time to collect accounts receivable. A lower number indicates better liquidity and cash management. The formula is shown taking revenue, accounts receivable, and days in the year to determine turnover rate and days to collect.
💰 #9 Return on Assets Ratio
This ratio measures the profit generated from the firm's assets, indicating how well assets are managed to produce returns. A higher number is better. The calculation uses net income divided by average total assets. Return on assets can also factor in net profit margin and asset turnover.
📈 #8 Return on Equity Ratio
Similar to return on assets, this measures shareholder investment returns generated by management. The goal is $1 of net income for every $1 of equity invested. It is calculated by taking net income minus preferred dividends over shareholder equity. The components can be analyzed to understand high or low returns.
🏬 #7 Inventory Turnover Ratio
This ratio measures how quickly inventory sells during a period. Faster turnover indicates better liquidity and working capital management. The calculation is cost of goods sold over average inventory level. A higher number is better, but depends on the industry.
🏦 #6 Debt to Equity Ratio
This leverage ratio indicates risks from debt financing. A higher number means more leverage and less borrowing capacity flexibility. It is calculated by total debt over total equity. Some debt can increase returns but too much increases risk.
💸 #5 Times Interest Earned Ratio
This ratio measures the firm's capacity to make required debt payments. A higher number indicates more financial security and income cushion for making interest expenses. It is calculated by earnings before interest and taxes over interest expense.
🛍️ #4 Gross Margin Ratio
This profitability ratio shows revenue remaining after cost of goods sold to cover operating expenses. A higher margin allows more flexibility. It is calculated by gross margin dollars over net sales. Gross margin is net sales minus cost of goods sold.
💱 #3 Earnings Per Share
This key investor ratio indicates profit allocated to each outstanding share of stock. A higher and stable number is better. Manipulation is possible through accounting choices. It is net income minus preferred dividends over weighted average common shares outstanding.
📉 #2 Price to Earnings Ratio
This compares earnings per share to the actual market price per share as a valuation measure. A higher number signals expectations for earnings growth. It is calculated by taking share price over earnings per share.
💧 #1 Current Ratio
The current ratio measures short-term liquidity and the ability to cover liabilities due within one year. A higher number provides a buffer and signals better liquidity management. It is calculated by current assets over current liabilities.
Mindmap
Keywords
💡Financial ratios
💡Liquidity
💡Leverage
💡Profitability
💡Working capital management
💡Shareholder value
💡Debt service coverage
💡Operating efficiency
💡Cash flow
💡Benchmarking
Highlights
Days sales outstanding measures how long it takes to collect payment from customers
Return on assets measures the profit generated from the company's assets
Return on equity measures return on shareholder investments
Inventory turnover measures how quickly inventory is sold
Debt to equity ratio measures financial leverage and borrowing capacity
Times interest earned ratio measures the company's ability to make debt payments
Gross margin ratio measures profitability on sales
Earnings per share measures profit per outstanding share
P/E ratio compares share price to earnings per share
Current ratio measures short-term liquidity
Lower days sales outstanding indicates faster payment collection
Higher return on assets indicates more efficient use of assets
Higher return on equity indicates better return for shareholders
Higher inventory turnover indicates more liquid inventory
Higher current ratio indicates greater short-term liquidity
Transcripts
hello and welcome to our top ten
financial ratios this is our listing of
the most commonly tested financial
ratios in Finance and Accounting exams
brought to you by passing score where
you can get more help on your exam prep
at passing score finance calm let's
start with number 10 our days sales
outstanding this is the average number
of days it takes our customers to pay us
back for our accounts receivable for
those invoices that we've sent them out
so this answers the question is how well
do we collect from our customers how
able are we to get our money back and
how are we managing our liquidity as
well the lower the ratio the better it
means that we're collecting our money
quickly and not having to use as much
operating cash or tie up funds in our
accounts receivable this is calculated
first by getting our receivables
turnover our revenue divided by our
average accounts receivable in this case
if our revenue was 850,000 and our
average receivable was 45,000 we would
have 18.9 or almost 19 times turning
over those accounts receivable this then
goes into our day sales outstanding
formula we take the days in the year and
divide by our receivables turnover of
18.9 to get 19 point 3 days on average
it took us to collect our money this can
also be calculated by taking our
accounts receivable and dividing by our
net credit sales which would have to be
kept track of separately in our
financial statements and multiplying by
365 but we should get the same answer
number 9 on our list is return on assets
a key indicator for how well the firm is
managing the investments made by the
company its the profit generated by the
firm's assets
and so we're asking what is the return
that we're getting so the higher the
number the better our ROA is calculated
by taking the net income and dividing by
our average total assets so in this case
128 thousand divided by 895 thousand of
assets means that we were getting a four
point fourteen point three percent
return which is pretty strong ROA can
also be calculated by taking our net
profit margin times asset turnover of
the firm number eight on our list is
return on equity so in this case similar
to ROA we're looking at the return but
on the shareholder investment not on the
total assets so we want to know how is
management management making use of the
investment the equity that I'm providing
to the firm and how much income is
actually generated for every dollar of
income that I get every dollar of
investment that I make an ROI of one
means that I'm going to make one dollar
of net income for every dollar of equity
invested in the firm and we calculate
this by taking our net income minus
preferred dividends we're looking at
common shareholder amounts and dividing
by our shareholder equity so in this
case we have 1.2 million of net income
minus 150 thousand dollars of preferred
dividend payments and dividing by 5.8
million dollars of equity to get an 18%
roee again a pretty strong number roee
can be broken down so that we can look
at the components and see what's
contributing to a strong or weak our OE
number we can take our net income
divided by sales our sales divided by
assets and our assets divided by equity
together to get to our our OE and we can
see in there the components that are
making up either a strong or weak number
and why number 7 on our list is
inventory turnover a key figure for
manufacture
and retail businesses it's the number of
times that our inventory gets turned
over or sold during a period so we want
to look at how this is looking at how
well is inventory managed is it sitting
on the shelves too long or is it getting
turned over quickly used and converted
into cash quickly which is tying in to
how liquid is the inventory of the firm
and the higher the turnover ratio the
better the more that we're selling off
the inventory and turning it into cash
over and over again the calculation is
the cost of goods sold the amount that
we're paying for our inventory divided
by our average inventory level in this
case a turnover of 3.8 means that our
inventory is sitting for almost three
months at a time which may be good for a
large manufacturing or construction
something like that but not very good
for something like retail number six on
our list is a debt to equity ratio so
here we're looking at the leverage of
the firm how much debts they're using to
get their results so a key question this
answers is how much leverage risk is
there is their debt to equity high or
low compared to peers in their industry
and how much could the firm borrow if
they need to if they have a very high
debt to equity ratio they might not have
as many people willing to lend to them
if they need additional cash some debt
is reasonable acceptable can actually
increase the return to the shareholders
but after a certain level the risk just
gets too high and it decreases the
flexibility of the firm to operate our
debt to equity is simply taking our
total debt or liabilities on the
financials divided by our total equity
in this case we get a 1.8 which means
that we have a dollar and 80 cents of
debt for every $1 of equity that we have
in the firm number five on our list is
the times interest earned the amount of
income available to make debt payments
in terms of how many times could we make
those debt payments so how financially
secure is the firm and how many times
could does the MIT there's a firm ache
debt income above its debt payments so
the higher the ratio the more
financially secure is the firm in this
case we take our earnings before
interest in taxes divided by our
interest expense in this case we have an
eleven point eight which is a very
strong ratio number four on our list is
gross margin the ratio of our cost of
goods sold to our net sales and so we're
looking at how profitable is it when we
sell in inventory and how much is
available beyond our cost of goods sold
to pay for operating expenses again a
key for the flexibility as well as the
profit profitability of the firm so we
get a higher ratio by decreasing or
reducing our cost of goods sold our
inputs and increasing our sales price if
we're able to maintain a high margin
high sales prices we're in pretty good
shape so we calculate this by taking our
gross margin in dollars and dividing by
our net sales in this case 718 million
divided by 1.2 billion would be a 60%
gross margin ratio which in most
industries would be very strong our
gross margin in the calculation is
taking the net sales minus cost of goods
sold
that's our gross margin and our net
sales as the gross sales less returns
and refunds so the amount that we
actually get to keep after everybody's
had a chance to return or refund our
product number three in our list is
earnings per share a key indicator for
investors it's the net income divided by
the number of shares outstanding in the
market and this is looking at how much
profit is there for shareholders in
their earnings and if you look at the
history of the earnings per share how
stable is the net income for my
perspective investment in this company
the higher the number the better but
there can be a lot of manipulation or
accounting issues that could obscure the
numbers so it's not always clear because
of the accounting what's going on if we
look at our calculation we take our net
income
again this is accounting income not
economic value or cash flow and minus
preferred dividends again we're looking
at the common shares and dividing by the
weighted average common shares
outstanding so on average how many
common shares were there in this case we
get 66 cents per share which would be
strong or weak depends on how much the
share price is so let's take a look at
that comparison in number two our p/e
ratio are very commonly used a financial
ratio not just in the exams but in the
financial press and in evaluating
companies it's a comparison of those
earnings that we saw to the actual
market share price that's being traded
out there so it's looking at how is the
market value in the stock are they do
they see strong prospects stable or
weakening and how many times earnings
should I pay for this stock is this a
growth company or is this strong
compared to the industry or weak it
depends on one thing you can look at is
the p/e ratio a lower number indicates
that there's poor or flat prospects
while a higher p/e ratio means there's
expectations that there's a strong
earnings growth in the firm a p/e ratio
is taking the market share price what's
being traded and dividing by the
earnings per share we calculated in
number three so in this case we'll have
a twelve dollar share price divided by
four dollars and 87 cents of earnings
per share would get us a p/e ratio of
two point four six which would not be
very strong
and finally number one our most commonly
used financial ratio is a current ratio
it's the ability of the firm to meet its
short-term obligation in this case
short-term is anything that would mature
or come due within one year so we're
looking at how liquid are the firm's
assets and can the firm meet its
short-term obligation can you meet their
payments are they looking strong or like
they might need help it's a good
indicator of their liquidity and also
the efficiency of management management
in managing the payments and assets of
the firm a higher is better and implies
ability to manage their debt it doesn't
tell us a lot about the overall debt
structure of the firm since we don't see
the long-term debt long-term obligations
which could be huge or insignificant we
take the current assets divided by the
current liabilities and again these are
due or maturing within one year or
expect it to turn into cash in one year
in this case 253 thousand divided by 98
thousand means we could cover our
liabilities about 2.6 times well that's
it for our top ten financial ratios if
you have any questions please feel free
to email me at John at passing score
finance calm and as always good luck on
your exam
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