Accounting 2 – ACCT 122 – Program #221 – Financial Statement Analysis

>>Hello, everybody! We are back. I have a busy day today. Let's go ahead and hop right in. I gotta do a few housecleaning chores here
before we start class. I know a lot of people who are not enrolled
in the class watch this class and it helps them with whatever studies they're in or sometimes
people are just interested in the subject, so this is for you. If you would like the handouts that we use
in this class, don't leave me a comment on YouTube. I don't read those YouTube comments that often.

Every now and then I'll go look at one, but
I don't, I don't check those comments every day. If you want the handouts, send me an email
address and maybe they can put my email address up there. It's always at the beginning of the lecture. But send me an email address and ask for the
handouts and be specific that you're asking for the accounting two handouts, okay? The accounting two handouts 'cause I have
an accounting one class as well. All right? The other thing that I get asked sometimes
is, how do we know when you update your lectures? And I'm gonna put this up again because some
of you have asked me this via email. The best way to know if we are making new
videos is to go, if you're on Facebook, go to that Facebook page and like it and then
I will post when we have updates on the videos. So I don't spend a lot of time reading the
comments on YouTube so if you write something there, I'm probably not going to see it.

All right. Let me go through my list. Let's go over quick study 16-12 right now. I wanted you to read a few pages and I wanted
you to do quick study 16-12, is that correct? All right. Let's go ahead and take a look at that. I'm gonna go ahead and just put it up there
so we can kind of look at it so we talk. Oops, I smeared my ink down there. Which of the following three competitors are
in the strongest position as shown by the statement of cash flows? And then analyze and compare the strength
of Moore's cash flow on total assets of that of Sykes. Well, you can see down here that this is their
net increase or decrease in cash, okay? And Moore and Sykes and Kritch have 36,000,
26,000 and 25,0000 respectively, increase in cash, right? But if you look at how their cash flows are
comprised, then we immediately see a problem with Kritch and we talked about this last
lecture. Your cash flow from operations is a number
that investors and external readers focus on. You should have your operations to fund your
business, right? To cash your business.

It should be a very important part of it,
at least. And their operations are not providing any
cash, they're actually costing $24,000 cash. So there's no question that Kritch is in the
worst position. All right? Okay? What about these other two companies? I would probably say if push comes to shove,
that Moore is in a little bit better position and the fact, but it's very similar. Their cash flows from operating activities
is a little higher, they were able to repay some debt, both companies bought some operating
assets which will hopefully in the future contribute to them being able to you know,
why do you buy operating assets? Why do you buy those sort of things? To hopefully help you generate revenue in
the future, right? So these are two, definitely the two strongest,
and argument could be made you know, on which one is the stronger, but this is definitely
the weakest, Kritch, correct? Now that reading also talked about your operating
cash flow and assets ratio, which is just your operating cash flows divided by your
average total assets and if you can read my numbers which got smeared a little bit, that's
8.9%, 9.6%, and negative 8%, okay? Again, these are very similar, this is definitely
weaker.

Does that make sense? That is about all we're gonna do on quick
study 16-12. Is there any questions? >>So which one's the strongest? >>Well again, I don't know that we can definitely
say of these two which one is the strongest. This one has a higher ratio, but I do like
the fact that this one has paid down some debt. But we don't even know; maybe this one doesn't
even have any debt. I think this is a situation where there's
not a clear winner. These are definitely stronger than this one,
but I think we'd need to see more information. They also, you know, this has a higher operating
cash flows than this one, but it also has more assets, right? So no clear winner, I don't think, between
these two except that they're both better than this one.

So. All right. Questions on that? Okay. This is something kind of unique that I do. I really feel like in accounting two classes
we don't talk enough about the interpretation of cash flow statements. Our objectives in this class really are to
focus on the mechanics of doing a cash flow statement, and we don't work on analysis of
it, interpretation. What does it all mean? So what I have done is, I actually, this was
lecture 221. After this lecture, I actually have a bonus
video.

It's like an extra on a DVD that you purchase,
right? It is a bonus video where I talk about the
interpretation of cash flow statements and how to analyze them. Now I realize that what I'm about to say is
immediately going to turn your brains off here. There is nothing in that bonus video that
you guys are responsible for on the test. Well, and let me say that differently. Everything you're responsible for on the test
is on the other videos. I mean, I restate some of the things that
I've said before on this bonus video, but I do believe it or not, there are people who
watch these videos who are not enrolled in the class who want to know these things 'cause
it's helpful for what they're doing in their classes and we taped a really nice segment
on analysis and interpretation of cash flow statements last year.

It was not for accounting two, so what I have
done is, I thought it would be good to have at least in the sequence of these. So you guys don't have to go watch it. I realize most of you probably won't, but
for those of you at home who watch these, if you want to watch that, it's clearly labeled
as bonus video over cash flow interpretation or something to the sort and it's in the sequence
and in the description to this video you will also see a URL link where you can click on
that to watch that. Does that make sense? So something kind of unique that I do. All right? Okay! The other piece of homework that I believe
I assigned was, what was it? Tell me. >>Foxboro. >>Foxboro. Okay, I'm gonna do something unique here,
too. I'm gonna simply lay the answer up here, okay? I'm going to simply lay the answer up here
for you to look at.

I am not going to go in depth through walking
through, walking through the step by step process of how I reached this conclusion of
that being our cash flow statement. However, come off that if you would, please. What I have also done, and this is a little
unique too, is I have made a little bitty video and it's probably about eight minutes
long where I very slowly and specifically walk through solving the Foxboro cash flow
statement, okay? And the URL to get to that is in the description
of this video as well, very clearly described as such, and it's probably in the sequence
as well. But I know for sure that the URL to the Foxboro
solution or the answer to the Foxboro cash flow statement that URL will be in the description
to this video that you're watching.

Does that make sense? So if you're like, "Well Dave, I'm looking
at this and I don't see how you got that." I don't want to spend class time today, eight
or nine minutes walking through that. If you want to watch that, it is available
to you and accessed in the ways that I just told you. You with me? Make sense? Okay. We are officially done with going over material
for the cash flow chapter 16. Cash flow statement. However, here is the way, do you know that,
remember that we did not have a complete cash flow statement on your last test? Okay. Well, I am not going to have cash flow statement
information on the next test. Here is the way I'm going to assess your knowledge
on if you can do a complete cash flow statement. Listen to me, this is very important. I have a Connect, a Connect assignment or
mini-project that is worth 15 points. You are gonna go out to Connect and do a complete
cash flow statement. Now here's what's really important: This is
worth 15 points towards your final grade.

It is not accumulated with your other Connect
assignments. You see what I'm saying? It is not part of that, it is separate. So it is worth more than your usual Connect
assignment. So if you're in the habit of blowing off Connect
assignments, don't blow off this one because I think I call it like a mini-project to try
to separate it a little bit but it is worth 15 total points towards your overall grade
and what it basically is, think of it as a take home, open book cash flow statement quiz. You with me? Worth 15 points. So that is out there on Connect, has anybody
seen that? >>Yeah, the mini-test. >>Do I say mini-test? >>In the syllabus.

>>Yeah, I don't know if I call it a mini-test
or what. The main thing I'm trying to specify is that
it is not included with the rest of your Connect assignments in how I grade it. It is a totally separate standalone 15 point
assignment. Are you with me? >>And when's it due? >>I don't know when it's due, but even if
I did I won't tell you on camera 'cause it messes up the people at home.

So uh, check the due dates, folks at home,
as always to when that's due and if you guys, I know it's at least five days from now. Okay? But maybe next time before the cameras roll,
somebody can clarify. I don't remember, to be honest with you 'cause
I put it out there last Friday. Okay? Questions? Lot of housekeeping stuff today. All right. Now what we are going to do is talk about
chapter 17. Now, chapter 17 is on financial statement
analysis. Financial statement analysis. Let's see how we can get to, there we go. Financial statement analysis is chapter 17. You can come off that. This is such an important chapter as far as
for your use in real life. I feel a little bit guilty because we're only
going to have a couple of class periods over financial statement analysis. This is a subject we could easily spend weeks
on if not a whole semester, if not a whole year.

If you get an accounting degree, you probably
will be required or highly encouraged to take a class on financial statement analysis. Very important. I think when I was going through school, to
be honest with you, I think we did a very poor job of learning this. But this is such an important concept. If you know how to analyze financial statements,
if you know how to look at trends over time, it is extremely beneficial to your business. And I'll give you some examples why as we
go through this lecture. There's so much material to cover in accounting
two, that there are subjects like this one that we almost just kind of touch on, right? Now if you take managerial accounting, we'll
go into more depth in this area, okay? Same thing with cash flow statements.

We actually go through cash flow statements
again in managerial accounting. But for financial statement analysis, we're
only going to briefly introduce it to you at this point. You've actually been briefly introduced to
a lot of things already, all right? Okay, what is financial statement analysis? What is financial analysis? Okay, I got a picture of a baseball player
here. Did anybody play baseball in high school? Okay. Okay, you can come off of that. Baseball has a ton of statistics that they
keep track of, is that correct? ERA, batting average, slugging percentage,
what are some others? >>On-base percentage. >>On-base percentage. >>WHIP. >>WHIP? What's WHIP? >>Yeah, walks plus hits per inning. >>Walks plus, I've never heard that one. Walks plus hits per inning. But they have all of these ratios.

Now, you played in high school, you two? Did they, did you have somebody who kept track
of this stuff for the team? >>I'm sure, yeah. >>Yeah, I'm sure you did, too. Coaches always keep track of this stuff. Why would a coach want to have that information? Because it's going to help them make better
decisions, right? Michael, for example, they could keep statistics
for you, and they could compare it to how you were doing last year or how you were doing
the early part of the season, right? Or what they could do is, let's say you played
first base.

They could compare it to the statistics gathered
for other first basemen, right? Or they could compare it to maybe statistics
for whatever league your team was in, right? Or there's also certain rules of thumbs. Rules of thumb that are used in analysis. For example, what's the rule of thumb about
your batting average? If your batting average is what or higher
is it considered pretty good? >>Your playing weight? >>Your playing weight? I've never heard that. I've always heard just 300. >>Yeah. >> If you're batting 300 or better, that's
generally considered pretty good. But it's just a rule of thumb, right? So, but the same reason and thinking process
for keeping these different created ratios and statistics for baseball players also applies
to the financial analysis that we do for businesses.

Going to the slides, it's kind of, it helps
us transform data into tools that will help us to analyze the situation more efficiently
and more effectively. It reduces the uncertainty, right? If I go, "Well, I think Michael's not batting
as well as, this year as he did last year," well why don't you get the statistics? I mean, let's gather his batting average,
right? And let's compare it to what he did last year,
okay? So it's the same sort of thought process. Now, and ultimately as I said, it helps users
make better decisions. Now. Just like those comparisons were made with
you, Michael, we have these same sort of comparisons with businesses.

We have to be able to interpret these statistics
and we have to have standards of comparison, right? It's not enough just to have a number, right? It's like when I go to the doctor and they,
they do like a cholesterol test and they go, "Your cholesterol is 39." And I'm like, "Well, okay. Is that good or bad? I don't know!" Right? Okay? So you have to have standards of comparison. Well, Michael, we said that we could compare
you to previous years, right? That is kind of analogous to intra-company
comparison.

Comparisons within the company in past periods. Or competitors. Like I said, I might compare you to other
first basemen, right? That's analogous to this one right here, this
standard of comparison. Now obviously it has to be a meaningful comparison. In baseball, you wouldn't want to evaluate
a pitcher's batting average compared to that of a designated hitter, would you? 'Cause those are two different positions,
right? Well, I wouldn't want to take the ratios of
a steel manufacturing company and compare them with the ratios of a flower retail shop,
right? Does that make sense? No, it doesn't make any sense. So that leads us to this next, this third
area of comparison which is industry. Sometimes different industries will put out
these monthly magazines, or monthly periodicals or quarterly, that gather anonymous statistics
from the industry so that you can compare how your specific company is doing in that
industry. Does that make sense? And then of course, as there are rules of
thumb, or more general guidelines in baseball like I said, a batting average of 3.0 or if
you bat 300 or more that's considered good? There is these rules of thumb or guidelines
in businesses as well.

For example, a rule of thumb is that your
current ratio, you want it to be at least 2.0, I've heard that. So. But do you see how these kind of relate? It's a lot like sports statistics. It's a lot like sports statistics. All right? Okay, we're gonna talk about three main tools
of analysis. We're going to talk about horizontal analysis
where we look across time at a company's performance. We're gonna look at vertical analysis, which
is their financial condition and performance at a specific time compared to a base amount,
and then we're gonna look at these ratios and we have talked about these ratios before. Even in accounting one we introduced the current
ratio, the acid test ratio, inventory turnover.

We just talked about the operating cash flow
and assets ratio and we went through quick study 16-12, right? So we're gonna kind of talk through these
today. Let's talk about horizontal analysis. Now, horizontal, we call it, remember horizontal
is left and right like the horizon, right? So think about that as we go through this. Horizontal analysis is sometimes called trend
analysis and it shows the changes between the years in dollar and percentage form, okay? Well first of all, we need to figure out the
dollar change which is pretty easy. We just take the analysis period amount minus
the base period amount and that's how much it's changed. Pretty simple. Then we want to figure out the percentage
change, and we do that by taking the dollar change divided by the base period amount. Let's look through some examples.

Cash from 2013 to 2014 went up by 15,000. So the dollar change was a 15,000 increase. Well what was the percentage increase? Well we take the dollar change, the 15,000
or 90 minus 75 divided by the 75,000 base period amount and we have a percentage increase
of 20%, right? Another way of saying that is if you took
1.20 times 75,000, you would get 90,000. Is that correct? It was a 20% increase. What about if the numbers are going down? Okay, accounts payable went down from 32,000
to 28,800 from 2013 to 2014. Well, the dollar change there is negative
32,000, right? Or 28,000 minus the base period amount of
32,000 and then we divide that by the base period amount. Okay? And in this instance, we have a 10% decrease. >>So do you wanna decrease in that situation? Is that better? >>Well, um, perhaps. I mean, we need to know more information,
but yeah, all things being equal, yeah, it's nicer to have lower liabilities.

But our accounts payable decreased by 10%,
right? And there's certain things you want to increase,
right? Like your salary, and there's certain things
that you want to decrease in life, like your weight. Correct? So you're right in knowing that we need to
know which way we want it to move. Now the book talks about horizontal analysis
where there's more than just one or two periods being analyzed. Let me come off that before I go to this example. This is one of my main complaints about the
way that accounting two textbooks teach financial analysis. They always do their trend analysis based
on this year vs. last year, right? Well that is, that's just not the most effective
way to do analysis, okay? Think about your financial statements that
you do. Don't you do financial statements for this
year and then you have last year, and isn't that usually the report that you issue? Well, trend analysis is not real strong if
you only use two data points.

Here's the example that I like to give, and
I may have said this in accounting one, you might remember it. But I have a son who is 18 years old. He's a senior. Well, when he started in kindergarten, they
take school pictures in the fall and then they take school pictures in the spring. Well my wife has a book that she bought years
and years ago where she puts his fall school picture on the left side of the book, and
then the spring one on the right, and that's kindergarten. Then she turns the page and does the same
thing with first grade. Fall first grade, spring first grade, right? And she's done that each year, correct? Well, if you open up that book and look at
any two pictures of my son right next to each other like fall of fourth grade vs. spring
of fourth grade, he doesn't look that different, right? Maybe his hair is messed up a little different,
maybe he's got a tooth missing, but it's not that much different, right, when you're looking
at two data points that are right next to each other.

However, if you look at his kindergarten picture
and compare it to his senior year, holy cow! This kid has changed, has he not? But you don't see those things. You don't see those things if you are looking
at trend analysis over too short of a period of time. And too oftentimes in accounting classes and
accounting education, they're looking at way too brief of a time period and then they're
calling it a trend. You with me? Give you another example. Take a look at the ELMO here. All right? Here's something else that I do. Over time, I had this little iPhone app where
I weight myself in the morning and I input it. I don't do it every day but maybe you know,
twice a week or something, okay? And I have done this for, oh I don't know,
four, five years? Since I've had an iPhone. Well, you can see trends over time, right? Now my weight has actually gone down over
five years, okay? But let's say that I was looking at a trend
and let's say this is over five years and let's say my weight was doing this.

Let's say my weight was doing that over five
years. Well I am clearly getting much heavier, am
I not? And that should cause, I should be concerned
about that. But if I'm just looking at a brief period
in time, can you really tell that this is going on? Can you tell that Krug is getting fatter? Heck oh! What if you're looking at that? Hey! You're doing a great job, Dave. Well, you're not really doing a great job,
Dave. You see what I'm saying? And I don't believe that people do in business,
do a very good job of financial statement analysis. When I go in to a client, I figure out some
of these key ratios: current ratio, gross margin percentage, acid test ratio, inventory
turnover, and I compute them at the end of each month 'cause they do monthly financial
statements and I do it for the past four years.

And I tell you what. There you see some trends. There you see some trends. What cracks me up is it's not even that difficult
to do this, and many companies do not do it. They don't do it. I have a friend who owns a business, has 40
or 50 employees, and I ask him, and I describe financial analysis to him and I ask him, do
you do this? And he says, I do not do this.

I go, why do you not do this? Do you not understand how to do this? I understand it. It's not that hard. It's not hard to figure out a current ratio,
is it? I don't do this, I'm very busy. And I say, but here's what I know about you. I know that you're in my fantasy football
league and I know you spend a lot of time perusing football statistics because you need
to figure up a third running back 'cause you're weak in that position for your analysis. Do you know what I'm saying? I go, you spend more time on your fantasy
football analysis than you do this company that you own that has 40 or 50 employees.

Is that not crazy? And we do the same things in our own lives,
right? We worry about fantasy football more than
our weight going up or whatever. But you need, this is so important. I'm getting on my soapbox today, I apologize. Here's another thing that has happened. A few years back, we had this financial crisis
and what was happening is a banks had loaned businesses money and these businesses could
not pay the loans back and so they had to be written off, okay? I had a client that called the consulting
company that I work with sometimes, and they wanted us to go look at this construction
company who was not paying their loan back. Their loan was two million dollars that they
owed this bank. Well, what we found out was, the commercial
banking, the commercial loan officer, here's what they were doing.

Every year they got the financial statements,
they'd pick them up and look at them, and then they would look at last year's, and they
would look mainly at the bottom line, the net income. Ah, they made money this year, they made money
last year, let's give 'em some more money. Well we did a much more in-depth analysis
of these ratios over the last four years. This company was clearly trending downward. It was clearly getting more unhealthy each
month. Bottom line was that bank wrote off a two
million dollar loan because that company went out of business.

This specific bank was not doing a good job
of financial statement analysis. They were looking at this year vs. last year
and that is not financial statement analysis, at least effective financial statement analysis. Does this make sense? A lot of you will own your own business someday. These are tools that you should utilize. Wish we could spend more than just a couple
of class periods on this. Back to horizontal analysis, though. Let me give you a real kind of simple example,
all right? Okay, you've got a married couple here, right? And they, here is the raw data of their combined
salaries over the last five years from 2010 to 2014 and here's the raw data as far as
their total household expenses. Well, you can see that their combined salaries
have increased over that time period and you can see that their household expenses have
as well. However, let's apply horizontal analysis as
your book talks about to this situation. If we do horizontal analysis of the combined
salaries, what we do is we take a 104,000 divided by 100,000 and we get 104%.

We take 106,000 divided by 100,000, we get
106% and so on, right? And of course your base year you take 100,000
divided by 100,000, you get 100%. And you, and since I had a base year of 100,
you know that these numbers are right. 104%, 106%, 109%, 2014 combined salaries,
114% of 2010 combined salaries. You with me? Now let's do the same with our household expenses. Again, 78,000 divided by 78,000 is 100%, 80,340
divided by 78,000 is 103% and so on. Well, the horizontal analysis tells us something,
doesn't it? The household expenses are increasing at a
faster rate than the salaries combined are increasing, correct? So that's something that needs to be addressed
and address it while it's still not that much of a problem.

Financial statement analysis allows us, if
we do it effectively, to identify problems before they're so big of a problem that it's,
that it's too late. This bank that called us in to analyze this
company, by the time my company, the consulting company I work with was called in, it was
too late. The patient was just about dead. But if they would have been doing financial
statement analysis over the last three, four years, first of all they wouldn't have kept
loaning them money and secondly they could have maybe corrected the situation without
the company going bankrupt. Are you with me? That's a quick example of horizontal analysis. All right? Powerful tool. But do you see how this trend down at the
bottom part here would not have been, been as readily identifiable by just looking at
the raw data? Cool? Let's take a look at vertical analysis.

Now vertical is up and down, right? Vertical analysis is when we focus on the
relationship on a financial statement at a given point in time, okay? And we express each item as a percentage of
a certain amount, okay? The base amount that we used for the balance
sheet vertical analysis is total assets. The base amount that we used for the income
statement is usually total sales. This is gonna be best Illustrated with an
example, so let's look at a fictitious company here, Highland Corporation for two years and
let's do common size statements, in other words, vertical analysis. Well, here is their two years of data. Just looking at two years for time sake here. Well, we're going to take every number divided
by the sales for that year. So this 69.2 is achieved by taking the 360,000
divided by the 520,000.

This 65.6% is a way of saying that cost to
goods sold for 2013 was 65.6% of sales and we got that by taking 315,000 divided by 480,000
and you do that for each item. Now this is just a real quick example, but
what conclusions can we draw? Well one thing that would jump out to me right
here is I would do horizontal analysis of our vertical analysis computations. Let me say that again. I would do horizontal analysis over time of
those vertical analysis computations.

And one thing that would alarm me a little
bit is they're gross, whoops, I circled the wrong one. Circled the wrong one, sorry. This is the one I meant to circle. One thing that would alarm me here is that
their gross margin percentage declined from 34.4% to 30.8%. That's not good, is it? That's a big decrease in gross margin percentage. So I don't know what's happening there, but
it tells us where we need to investigate. Is the cost of our goods that we sell increasing
and we're not able to pass those on to the customer? Or we're just not passing them on to the customer
or what? But our margin is eroding. You see that? We take everything but divided by sales for
the year to get all of these numbers. As I said, horizontal analysis of vertical
metrics is a powerful tool and perhaps you see that gross profit percentage is declining
over time or if you do net income divided by sales it is declining over time, okay? When I did this, this is horizontal analysis
over time of a vertical measurement, isn't it? And you can see that whoever this person is,
is great, he's getting quite large, right? Address the situation before they have a heart
attack and die, right? Seriously, I said this before.

We want to try to solve problems while they're
still solvable. That's why we use these metrics and why we
use this analysis. Back to the computer. Some real world examples of when this was
used. Subway did this sort of analysis back in '08
and they realized they had an advantage in their margin due to their low food costs. And what they enacted was the five dollar
foot long campaign and they did have a decrease in margins but from their analysis they knew,
or they suspected that it would be more than offset by volume increases and they were correct. Total net income increased. Now Quiznos tried to follow suit, but they
had a lower gross margin because their food costs were much higher.

They tried to do the same sort of strategies
as Subway and their margins eroded and they could not make them up in increased volume
and a lot of franchises actually went out of business including the one that I liked
to go to. So this is a quick example of how this has
been used in real life. On a balance sheet, we do vertical analysis
but we take everything divided by the total assets number. That is the base number we use and you can
see this right here. Every one of these numbers were divided by
total assets to get whatever number it is.

Now something like this is so much easier
if you know how to use Microsoft Excel. If you take managerial accounting from me,
you'll learn how to use Microsoft Excel if you don't know already. And then of course we can a lot of times use
this, make a circle graph out of some of this data as well and that can be used in our analysis
purposes as well. Now let's talk quickly about some of these
ratios that we utilize. Now I'm going to have to zip through this,
but you can look through these slides and you can look through the chapter a bit, okay? Now.

Too much of our attention it seems in accounting
education is on how do you compute these ratios? Where I wish we could instead focus on interpreting
the ratios. You with me? Keep that in mind as we go through these. There's four primary categories of ratios. There's those that have to do with liquidity
and efficiency, those have to do with solvency, those with profitability, and those have to
do with market prospects and some of these we actually addressed back in chapter 13.

You remember when I had you do that Connect
assignment where you read those pages and you did that quick little Connect assignment? Some of those were addressed back then. Let's talk about liquidity and efficiency. This is such an important set of ratios. Your current ratio, your acid test ratio,
remember those ratios? Those measure your ability to pay your debt
in the short-term. Your accounts receivable, your inventory turnover,
those sort of things.

Let's look through these. Again, short-term creditors like to focus
on this when analyzing a company because this measures our ability to pay our debts in the
short-term. Remember the current ratio? Our ability to pay short-term debt? We do current assets divided by current liabilities,
right? This is a very important ratio that I always
compute for my clients and we look at it over time to see if it's deteriorating. There is, and you can see how you just divide
numbers and you get some amount, okay? There's also the acid test ratio which measures
the same thing as the current ratio. That is, the ability to pay short-term debt,
but it does it in a little different way. It recognizes that not all current assets
are equal, right? If you have $20,000 worth of cash as your
only current asset, you are in a much better position to pay your short-term debt than
somebody who has only $20,000 of current assets but it's all in inventory. You see that? So the acid test says, now we're only gonna
count in our numerator those, what we call quick assets.

Those that are very liquid such as cash, short-term
investments and receivables. Okay? You can see the definition of quick assets
down here. Quick example of how this might be beneficial. We have three fictitious companies here and
I give you this information. Now you folks at home, maybe you want to pause
this real quick and calculate the current and acid test ratio and then push play when
you're done. But the current ratio and the acid test ratio
leads us to different conclusions. As far as current ratio, Company B has a healthier
current ratio than A or C. However, a lot of their inventory, or a lot of their current
assets are inventory and prepaid expenses which are not nearly as liquid as cash, right? So if you look at the acid test ratio, C,
Company C clearly has the superior ratio because they have a lot of their current assets in
those liquid assets of cash, short-term investments, and receivables. Does that make sense? What about accounts receivable turnover? Okay, come off that for a second.

Anybody here worked as a server in a restaurant? Okay, Jeremiah. Daniel has, too. What you want to happen in your restaurant
is you want your table to turn over quickly, right? You want people to come in, you seat them,
they order their food, you bring their food, they pay their bill, they tip you and then
they leave and somebody else comes and fills that spot.

Did you ever have campers? >>Yes, they're, they're terrible. >> That they come in, they eat, they pay,
they maybe tip and then they just there and talk about the Royals for two hours and there's
people at the door that want to sit at that table but it's, they're talking. Turnovers in football and basketball are bad
things, but there's certain sorts of turnover that we want. We want our table at the restaurant to turn
over so we can get more tips. We want our receivables to turn over. We want them to be collected quickly. We want our inventory to turn over. We want to buy inventory, it's sold, we have
cash, we buy more inventory, it's sold, we have more cash.

We want it to turn over like this. These next ratios up here, which I'm not gonna
read each computation because of time, but these measure those factors. Accounts receivable, turnover. How many days uncollected in sales do we have? How long is it taking our receivables to come
in? Are our receivables slowing down? Inventory turnover. How many times does our inventory turnover
in a year? What is our day sales and inventory? If we stopped purchasing inventory, how many
days worth would we have to sell before we ran out? Very important. Now let's talk about solvency ratios and these
are more for the ability to pay debt in the long term. You've got the debt ratio, the equity ratio,
the TIE ratio, the debt-to-equity. These all pretty much measure the same thing
but in different ways.

The debt ratio. You compute your total liabilities as a percentage
of your total assets. Now, for a company, is that something that
they should know? For Johnson County families, is that something
they should know? Maybe they can see their debt increasing over
time? You have to pay that debt back eventually,
right? So there's different ways to measure that. The TIE ratio takes what we call EBIT, which
is your earnings before interest and taxes have been deducted and divides that by interest
expense.

Now all things being equal, do you want your
TIE ratio to be high or low? >>High. >>Here's what I always ask. Well, a high ratio would mean a high earnings
and low interest expense. A low TIE ratio would mean low earnings and
high interest expense. So now let me ask the question again. Do we want this ratio to be high or low all
things being equal? >>High. >>We want it to be high. We want our numerator to be high. This is another way of measuring that and
of course you could go your debt-to-equity ratio as well. All right, quickly let's talk about ratios
that assess profitability.

I know we're about out of time here, we'll
go a couple minutes over. We've talked about these as well even in this
presentation that we've done. Gross margin percentage, profit margin. ROA. Return on assets, okay? Return on stockholders' equity. Okay, let's talk about profit margin. Profit margin is calculated by taking net
income divided by net sales and this just describes how much of each sales dollar actually
is going towards net income, okay? Now we talked about that a little bit in some
of the previous slides when we were looking at margins. We also talked about gross margin ratio. The gross margin ratio is calculated by taking
the gross margin divided by sales. Now remember gross margin and gross profit
are the same thing and remember that gross profit or gross margin is calculated by taking
net sales minus your cost of goods sold, but this is how much of each sales dollars is
left after deducting cost of goods sold.

Remember when we were talking about margin
erosion? These two ratios, gross margin and profit
margin ratios are the ones that we analyze over time. Margin erosion, if these are getting less
over time that can be a real problem. Along with this is return on assets. Now this book calls this return on assets
but I also want you to be aware that there are some books that call this the ROI, return
on investment, okay? So if you ever see that term, know that it's
the same thing.

We compute ROA by taking our net income over
our average total assets, okay? And this measures how are we in generating
income from the assets that we have? How are we in generating income from the assets
that we have? Another way of saying it is as written there
it's the measure of the overall profitability of those company assets, okay? Now one kind of, we want to, we want to maximize
this ratio. We want this ratio to be high.

Now another way of looking at the ROA is as
the product of two other ratios. There's the original ROA ratio, but we could
also take a look at the profit margin ratio which we discussed earlier as well as a new
ratio called the total asset turnover ratio. This ratio measures how much sales we are
generating from our assets. So take a look at this. I think this'll clarify it. ROA is also measured by taking profit margin,
this ratio right here, times our total asset turnover, which is right here. And this kind of makes sense if you think
about it and you think about how those ratios are calculated, okay? If profit margin is net income over sales,
and total asset turnover is sales over average total assets, what we know from grade school
when we multiply fractions that we can kind of cancel those things and that's what is
left is this original formula.

Now why do we go through this? Well, we go through this because business
owners want to maximize ROA. They can think of this as, we could do that
by increasing our profit margin, the amount of net income that is generated from our sales,
or and or we could increase our ROA by improving our total asset turnover which is the amount
of sales that we're getting from those assets and the efficiency of that, okay? So that can increase by either increasing
this or this or certainly both. Now there is the total asset turnover which
was introduced in the previous slide. Again, this reflects the company's ability
to use its assets to generate sales. And then in this section is the return on
common stockholders’ equity. Okay, not the return on assets but the return
on common stockholder's equity. And we compute this by taking net income minus
your preferred dividends. We want to get that out of there since we're
just concentrating on common stockholder's equity. Divided by your average common stockholders’
equity.

This is how well the company is doing in using
the owner's investments to earn income, all right? Now with this ratio and with all of the ratios,
I really think it would behoove you to not just use these slides but read through your
chapter, read through the way that your textbook describes these and they give you some examples
in calculating these and what you would include or what you would not include, and I think
that will be helpful if you do that before you do your homework or your, any of the assignments
that I give you in regards to chapter seven or 17, I should say. Okay, a few closing thoughts. Now the limitations of this is you obviously
need to not just concentrate totally on ratios, but you need to look at trends in the industry. Maybe there's some big changes that are happening
within the company. Maybe the economy is not doing well. There's other things you need to take in consideration
as well. One final warning is you also need to, when
you're comparing to other companies, they may have different methods of accounting.

For example, we might use the LIFO method
where they use the average cost method. So you need to make sure that you're making
meaningful comparisons, okay? Okay, come off that a bit. I know that was a lot of information in a
short amount of time. I wish they'd give me more weeks to teach
accounting two 'cause it's very difficult to get all this information in time. Okay, this is the homework I want you to do,
I know it looks like a lot. These three are real quick and this all has
to do with the same set of data, okay? High probability of a homework check for you
folks here, okay? I want you to do this homework, okay? Because we don't have a whole lot of time
on this subject, I want to make sure we do what we can with the time we have.

So take a look at your homework, please do
this. Okay, I know it was a lot today for you folks
at home. If you need to watch it again or if you need
to take some breaks by pausing during there, I understand. It's an important subject, I wish we didn't
have to rush through it too much. You will revisit it again in your business
education. Make sure you do that homework I just told
you about, and we will see you next time. Bye bye..

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