In module three, we’re going to be looking at ratios.
Ratios can be a lot of fun because they’re quick, they’re easy.
We can often I, of often identify opportunities and threats so there’s a lot of correlation between a SWOT analysis and performing ratios.
The great thing about ratios also, is that ratios are just that, they’re ratios.
Which means we can take a huge business and we can take a very small business, and by running the ratios we’re going to be getting fractional numbers or percentages.
Now, before we get on with the ratios, let’s look at what ratios really are.
Ratios are quick and dirty, okay, ratios do not take us a lot of time usually.
With efficiency usually can come reduced accuracy, okay? And ratios are highly efficient, therefore accuracy of a single ratio can often be or can sometimes be minimal, nominal.
Okay? So you don’t want to look at just one ratio.
When you want to run, when you run ratios, you want to run several ratios.
Torture them too long and they’ll say whatever you want them to say, right? So, again, the great thing about ratios, you’ve got some standard ratios, we run some ratios.
Now, the first classification of ratios that we have, what we call liquidity ratios.
How liquid are they? How much cash do they have? And in the liquidity ratio, what we’re concerned with is we want to know how quickly a company can convert what it has, its assets into cash.
So assets are great, but how quickly you can convert those into cash? We’ve got a few different liquidity ratios.
In fact there’s many different equity liquidity ratios.
I go to investopedia all the time if I want a new ratio, if I’m wondering if there is a ratio I can use that, that’s going to tell me this or that, or, or different ways to calculate a ratio.
We’ve got these ratios but as you’ll see in the course material there’s sometimes, there’s two, or even three different calculations for that ratio.
We say well that’s the ratio and this is how we calculate it, but we can also calculate it this way.
So the first one is called the working capital ratio and basically, it’s showing how much well this one is current assets divided by current liability.
So the same thing that we just looked at with the working capital ratio, except this one takes out our, our inventories, right? Why? Well, because maybe it’s not so easy to turn your inventory into cash.
3.2 Asset, Profitability, and Debt Ratios
The next family of ratios we have are asset turnover ratios.
We want to look at the utilization of those assets.
If I have stock, how often does that stock turn over? Another asset that I have is accounts receivable.
How quickly do I collect on my accounts receivable? Things like this.
Asset turn over ratios often times express the ration in the terms of days.
Here we’re going to look at the inventory turnover ratio.
It’s going to give you how many days it takes to sell your inventory.
How efficient are we in collecting the money that’s owed to us? This one here is average accounts receivable divided by average daily sales.
Now these are a class of financial metrics that help us assess how profitable our business is, the bottom line in the business, how we’re performing.
What return on equity really tells us is if we look at all the money that owners have paid into the company, or left into the company, the money that’s in there, the equity in the company, and we look at the equity as the generator of income, so what if that’s what’s generating income, and we know there’s other things, but we want to look at that.
How much income was generated by that equity? And, that’s what ROE tells us.
Next one that’s important is return on assets, right.
Why do we have assets? We use assets to generate income, right.
If we look at instead of looking at equity we look at the assets, let’s look at what we own.
How are the assets generating income? Then we have ROA, return on assets, net profit instead of divided by equity for ROE, net profit divided by total assets for ROA.
One of the problems with this, right? Well in some businesses, particularly big businesses and old businesses, they probably have some assets that either are not listed at their true value today.
That’s going to make our ROA look a little bit friendlier than maybe it, it really should be compared to a newer business that only bought their building last year, right.
Sometimes companies have assets that simply are sitting around doing nothing, storerooms full of equipment’s, supply, just sitting there.
When we use all of our assets of course, we’re getting a little bit of a skewed view.
On the other hand, one of the things that ROA can, can show us if it’s too low is maybe we need to offload some of the assets we’re not using.
Remember how I said, on ROA you can have some A? You can have some assets out there that aren’t actually, you know, working or aren’t actually employed.
This one breaks that down a little bit further and says look we want to look at the earnings on the capital that’s actually being employed in this process.
So what this does is we’re going to look at earnings before interest and tax.
Also known as EBIT, and we’re going to divide that by our capital employed which is assets minus current liabilities.
Our next family of ratios are the debt ratios okay as the name implies this is basically how we look at a companies debt what companies owe.
In this what we’re really looking at is we’re looking at what we call the financial leverage of a company.
How leveraged a company is, is how much how much money they owe.
Because as we get on, especially the next module, the final module, we look at valuation.
We’re going to start looking at the cost of capital.
So there’s really that there’s, there’s a good balance of leveraging that we’re often looking for in a business.
Total debt divided by total assets.
Shows us based on how much we have, how much of that do we owe? Sound familiar like the balance sheet.
Looking at the amount of debt based on the amount of equity we have.
They’re basically just giving us a view of how much we owe in terms of how much we have in assets, how much we have in equity.
A lot of times what most analysts are looking for is about double the debt as the equities.
3.3 DuPont Pyramid
How efficient is the business running? How much, how efficient is it producing its profit? The next one is asset use efficiency, and that’s the total asset turnover.
Which is sales or revenues divided by assets and that’s going to show us how efficiently the business is utilizing the assets that it has, okay.
When I’m evaluating companies in the sector what I like to do is I like to choose the companies I want to evaluate, and I really quickly run ROE on those companies.
An ROE is going to show me which company is the better performer, right? Over all, of all of these.
Then I like to do the DuPont Pyramid and go into it and see what is driving up the ROE on a company and what might be bringing it down.
So it’s just a great way to get into the analytics of a company, or a set of companies and get some more information quick and dirty, but very relevant information that we can use, that’s the DuPont Pyramid.
3.4 Earnings and Dividends
His final classification of ratios we have are the earnings and dividend ratios.
That’s how much the company earned for each piece of, for each share outstanding, earnings per share.
The final earnings and dividend ratio is the price-earnings ratio.
The price-earnings ratio basically tells us how much the market is willing to pay for each dollar of profit in that company.
The more confidence that you have that a business is going to make money, the more you’re willing to pay for the money that that company generates, right? Whereas, if the money that a company is going to generate is dubious, or you’re less certain, you’re going to pay much less for it, right? So, the price-earnings ratio is really a ratio that shows market confidence in the performance of a company.
You’re actually able to see how the market is, how confident the market is in the projected earnings, or the future earnings of that company.
Again, there’s so much more to learn on ratios.
We are going, we have some, exercises for you to use the ratios, to calculate things, and to see what conclusions you can draws by doing so.