Financial Ratio Analysis and Benchmarking

Using ratios to manage businesses and analyze industries

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You’ve put in a lot of hard work into this course, and I know a lot of it has been difficult and challenging, but now we are getting to the fun part. Now we are looking at the ratios and the benchmarks. This is giving us context now to understand all the different ratios that we are about to go over. In order to understand net profit, or days in inventory, or debt to equity ratios, you have got to understand the balance sheet and the income statement. Now you’ve got the tools so that you can do the fun work of analyzing businesses, analyzing your own company, and analyzing industry leaders.

Financial ratios are a great way to analyze a business and far better than actually looking at raw numbers. You can compare a company’s performance year over year using ratios, or you can use the ratios to compare a company to industry competitors. For example, let’s say a company earns $100,000. So how is that? Is that good? Is that bad? Well, if you think about their revenue and they had $1,000,000 in revenue then you can say ‘oh, they had 10% profit margin’. Now we can start to analyze: is 10% good? Well, how did they do last year? Last year, they had 20% profit margin, in which case 10% is not so good. Maybe their competitors had a 15% profit margin; how are they doing at 10%? Now you actually have something to go on.

You can common size companies as well. How do you compare a 1 million dollar company to a 5 billion dollar company? Looking at raw numbers, it would seem that the 5 billion dollar company is doing fantastic: they’ve got 5 billion dollars in revenue! But then if you start to look at the financial ratios, you can see: how are they operating? Is their profit margin as high as the 1 million dollar company? It could very well be that the 1 million dollar company is doing better, because they are smaller and more nimble and their ratios are looking a lot better.

Ratios can also help you target against benchmarks. For example, let’s say you want to have your inventory days be at 12: you want to have your average inventory in your storeroom for 12 days. By using a ratio, now you have got a benchmark that you can compare your performance. How long did you keep your inventory? Was it 15 days –– was it 3 days longer than you wanted? Maybe it was 10 days. What do you think about that? Maybe 10 days is too short, it means that you don’t have enough inventory in hand for when customers come in and want to by something. But without having these ratios, you don’t have enough information to evaluate how your company is doing.

Most ratios are important for company managers and owners. How profitable is a company’s profit margin and gross margin? How well is it using its assets: asset turnover, inventory-days turnover? How well is it managing its cash flow? How leveraged is it? Most of the ratios that you are going to learn are very important for business managers and owners. But there are also some ratios that outside analysts are going to want to know. For example, if you are going to the bank and want to borrow some money, they are going to want to know how leveraged you are. How much debt do you have in comparison to the assets that your company has? If your company is public and trading shares, investors are going to want to know what your earnings are per share. There are a lot of different ratios that are very good for different stakeholders, and we are going to go through those bit by bit so that you can learn more.

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