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Ratio Analysis

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Source: Instrumental “Drops of H2O ( The Filtered Water Treatment )" by J.Lang (feat. Airtone),” Creative Commons, http://ccmixter.org/files/djlang59/37792

[MUSIC PLAYING] Hey, everyone. And welcome to our video today on ratio analysis. So what is today's video about? Well, first we need to have an understanding of what a financial ratio is. That evaluates the relationship between specific items on a financial statement. So that's a financial ratio. So today we're going to be performing ratio analysis. We're going to be looking at profitability ratios, as well as liquidity ratios. But let's go ahead and start with discussing our profitability ratios. What do our profitability ratios do? They measure the operating performance of the company. So they help us understand and evaluate our performance. What ratios are we going to look at today? Well, we're going to start with the rate of return on sales, which measures managerial efficiency, as well as profitability. Then we're going to look at return on total assets, which measures the effective use of assets, and managerial efficiency. And the last profitability ratio that we're going to look at today is asset turnover, and that measures the use of assets to make sales. So now let's look at examples of all three of these ratios, as well as the individual formulas for those ratios.

OK. So our first piece of ratio analysis is doing our profitability ratios. And the three ratios we just talked about are, rate of return on sales, return on total assets, as well as asset turnover. So let's look at that first ratio, rate of return on sales. Now the formula is net income divided by net sales. So that's going to tell us how profitable we are as a business. So if we plug-in some figures for net income and net sales for our example, we would get a rate of return on sales of 27.8%. So now if we look at return on total assets, that formula is income before interest expense and taxes, divided by total assets. And that's going to tell us how effectively we use our assets to generate income. So if we plug-in some numbers for that, in this case we would get a return on total assets of 26.8%

So now if we turn to our asset turnover ratio, that's net sales divided by total assets. So that helps us measure the use of assets to make sales. So if we plug-in some figures for net sales and total assets, we would see that it's 0.9 times. So our assets turnover 0.9 times during the year.

Great. So now that we've seen how to calculate our profitability ratios, let's turn our attention to our liquidity ratios. Now what do our liquidity ratios do? They measure the ability of the company to pay debts when they are due. So they help us understand our ability to pay our debt obligations. Now what ratios are we going to look at today? Today we're going to look at the current ratio, which shows how much in current assets a company has in order to pay its current liabilities. And then we're also going to look at inventory turnover, which measures the number of times the inventory that a company has is sold and replaced.

So now let's go back to our examples. Let's go through some examples of calculating these two liquidity ratios, as well as the individual formulas for both. OK. So now we're going to be doing our ratio analysis for our liquidity ratios. And the two that I just mentioned are our current ratio, as well as inventory turnover. So if we start with that current ratio, it's current assets divided by current liabilities. So if we plug-in some information for our example, for our current assets and our current liabilities, we get a current ratio of 3.74, which means we have 3.74 times more current assets than we do current liabilities.

OK. So now let's turn our attention to inventory turnover. Inventory turnover is calculated as cost of goods sold divided by average inventory. So if we plug some information in for those details, we'll see that our inventory turnover is 2.0 times. So that's the number of times the inventory is sold and replaced. Now again, these liquidity ratios, to have context we would need to know things like, what were our ratios last year, what are other companies ratios, and what are the industry standards.

Great. So now that we've seen how to calculate our liquidity ratios, let's go ahead and summarize what we talked about today. In a nutshell, we performed ratio analysis. We looked at our profitability ratios. We looked at rate of return on sales, return on total assets, as well as asset turnover. And then we did our liquidity ratios. We looked at the current ratio, as well as the inventory turnover. I hope everybody enjoyed this video, and I hope to see you next time.

**Financial ratio**

*Evaluates the relationship between specific items on a financial statement.*