I'm Larry Walther, this is

principlesofaccounting.com chapter 16. This module considers tools for

financial statement analysis. Now, recognize that CPAs and

the Securities and Exchange Commission and so

forth provide safe guards to ensure the integrity of

reported financial information. That's entirely different than suggesting

that a particular company might be a good investment. In other words, a report that shows that

a company has more depth than assets and is losing money, that can be reported

with great integrity and those financial statements might be filed and accepted

with the SEC and audited by a CPA. That doesn't guarantee that

something's a good investment. So someone needs to look at financial

reports when they are considering loaning money or

making an investment with a company. They need to look at financial

statements very carefully and see what information is communicated. And throughout the textbook, you've seen a number of ratios

that have been illustrated.

I tried to integrate each of

the ratios that are that are typical into the textbook, through the textbook

as those subjects made sense. The ratios are key metrics or key indicators that can be used to

summarize financial position, performance, and so forth, and use that for

a comparative basis with other companies. What I wish to do next is

review the ratios that you've been exposed to in your

studies to this point.

Ratios can be divided into certain

types or categories of ratio. I've identified two liquidity ratios. Liquidity, or a company's cash or

near to cash position, its ability to meet

obligations as they come due. In Chapter 4, we saw the current ratio, which is current

assets divided by current liabilities. On the far right are some calculations of

the current ratio for Emerson Corporation. In the textbook, the financial statements

for Emerson Corporation are presented. You might want to open up, or

look alongside in your textbook and see if you can find the amount for

current assets, current liabilities, to come up with that ratio. You can pause the video if you need to. Another ratio is the quick ratio,

it's a measure of liquidity also. It's even tied to a more stringent

definition of liquidity, though. Rather than looking at total current

assets, it looks at the current assets that are very near to cash, which

include cash, short term receivables and account receivables divided

by the current liabilities.

And there again is the value for

Emerson Corporation. It appears in both cases that Emerson's

Corporation liquidity, as expressed through the current ratio and the quick

ratio are both in pretty good shape. Another family of category of

ratios are the debt service ratios. We have debt to total assets that

was introduced in Chapter 13. It's the percentage of assets that

are financed by long term and short term debt,

total debt divided by total assets. A similar ratio, debt to total equity, where we divide total

debt by total equity. Times interest earned was also

introduced in Chapter 13.

It is the amount of

income before taxes and interest divided by the interest charges. Now, you might look at other textbooks and

finance books, you'll find this ratio calculated

several different ways. But in the main, what it's an attempt to

do is show how many times you have money available to cover your

fixed interest obligation before you would run

into financial stress.

Emerson's apparently doing pretty good. $1.4 million in income before taxes and

interest. Their interest expense or interest

charges are $100,000 for the period. So they've got their interest

covered at least 14 times. Turnover ratios is another category. In Chapter 7 we introduced accounts

receivable turnover ratio. It measures the frequency

of the collection cycle. It's used to monitor credit policies. It's net credit sales divided by

average net accounts receivable.

And then from Chapter 8, we introduced

the inventory turnover ratio, which is the cost of goods sold

divided by the average inventory. If these ratios are changing for a

particular business, it can be indications of building credit risk, companies not

collecting their receivables, or building their inventory, they're not turning

their inventory on a consistent basis. So it's important to monitor

those particular turnover ratios. We've got certain profitability ratios, net profit on sales is

introduced in Chapter 5. It's net income divided by net sales,

often used for comparing one business to another,

companies in the same industry. You would probably expect them to

have similar profit rates, but that's not always the case.

Gross profit margin is gross

profit divided by net sales. Of course it compares that intermediate

income number before considering all of your operating expenses. Return on assets is the net

income plus the interest expense, it's how much is being made before

interest divided by the average assets. So this company's generating a 28%

return on its invested average assets. And return on equity is somewhat similar.

We do need to subtract

preferred dividends, so it's the net income less the portion

that needs to be distributed as preferred dividends divided

by the average common equity. In this, Emerson appears to be doing

quite well, with a 48% return on equity. There's certainly other indicators. We looked in chapter 15 at earnings

per share, which is the income available to common shareholders divided

by the weighted average number of shares. We looked at the price earnings ratio, which compares the market price of

the stock to the earnings per share.

The dividend yield, which are the cash dividends divided by

the market price per share of the stock. Dividend payout ratio, which is what

proportion of the income is being paid out in dividends or in other words,

dividends divided by earnings. And then the book value per share in

common equity divided by the number of common shares outstanding. Beyond just the ratios, the textbook

also presents and illustration for Emerson Corporation using common

size financial statements. This is simply ratios, for example, for

20×5, cash was 17% of total assets, receivables were 21% of assets,

and so it would go. That's interesting and probably

apparent where the numbers come from. But also important is to

monitor year to year. So, for example, something that

jumps out at me in this illustration is that in 20×5, long term loans were 22%

of the total liabilities plus equity, whereas in the previous year it was 50%.

Notice that equity is now 71%

of the organization's financing, the prior year, 43%. So it very much quickly, at a glance,

tells you how things are ebbing and flowing within an organization in terms

of its overall financial structure. We could do a similar presentation for

a common size income statement..