Financial Ratio Analysis Tutorial Part 1: Introduction, Liquidity Ratios the Current Ratio

hello welcome to subject money comm in this series we are going to cover different financial ratios that are used when analyzing a company financial ratios are considered among a large majority of analysts to be the most important element when conducting a financial analysis voucher ratios can tell you where a company stands compared to its competitors how efficiently the managers are operating the overall health of the company how close it may or may not be to financial distress and many other factors of you as an investor would want insight on and this lesson we're going to be going over many different financial ratios we will highlight the most important financial ratios and will show you their strengths and their weaknesses we will use real-life data by comparing two publicly traded companies that operate in the same industry we will use data from the most recent annual reports which contains the financial statements needed from Pier one Imports ticker symbol PIR and Bed Bath & Beyond ticker symbol B BBY to calculate our ratios and to compare the ratios PIR and V BBY to each other generally ratio analysis is most effective when comparing similar companies that both have similar functions for example comparing the financial ratios of a bank with the retail store will be pointless as banks operate in a much different manner than retail stores therefore their ratios are going to be much different as you can tell there are many different ratios that can be used for performing a ratio analysis and these ratios fall in separate categories the categories of these ratios are liquidity measurement ratios profitability ratios debt ratios operating performance ratios cash flow indicator ratios and investment valuation ratios just about every ratio use will give the components or the numbers needed to derive the ratio from the company's financial statements such as the income statement the balance sheet and the cash flow statement so let's go ahead and jump right into this the first set of ratios that we're going to cover are known as liquidity measurement ratios liquidity measurement ratios are ratios that attempt to measure a company's ability to pay off short-term debt obligations if they were to come due these measures do this by comparing a company's most liquid assets to its short-term liabilities in general the more current assets company has relative to its short term liabilities the more likely it would be able to pay off of short-term liabilities if they were to come due the liquidity measurement ratios that we are going to cover are the current ratio the quick ratio the cash ratio and the cash conversion cycle the biggest difference among these ratios is the types of assets used with some ratios being more conservative than others the first ratio we're going to cover is liquidity ratio called the current ratio the current ratio is a ratio used to determine how well a company could pay off of short-term liabilities with a short term or current assets current assets are cash and other assets that can easily be converted into cash within 12 months since current assets can completely converted to cash if the company was required to pay off all of its current obligations it should be able to convert all current assets into cash in order to meet in short term obligations the current ratio can be defined as all current assets divided by all current liabilities current ratio above 1 is usually considered good and anything below 1 is a signal that there may be financial problems on the horizon generally the higher the ratio the better however this may not always be the case the company could be very conservative by keeping most of its assets liquid in the form of cash although cash is important the company could become so conservative that it does not take advantage of investment opportunities that require the use of cash a company could continue to pile up cash therefore propping up its current ratio but this would not be good for the growth and profitability of the company since it would be missing out on profitable investments conversely the company becomes too aggressive and has a low current ratio it may not be able to tap into low-interest funds by borrowing from banks this is because banks love to analyze potential borrowers by looking at ratios by keeping the liquidity ratio such as the current ratio high companies are able to tap into low-cost borrowing from banks and other lenders another important thing to consider here is that the current ratio uses all current assets this includes cash and cash equivalents marketable securities accounts receivable inventories and other current assets and theory these assets can all easily be converted into cash however in reality this isn't always true for example the value of inventory reported on the balance sheet might not be accurate especially if the company's inventory consists of items that nobody wants if a company has inventory that is not in demand they may have to sell it off a huge discounts in order to convert it into cash within a short period of time now let's go ahead and calculate the current ratio for Pier 1 and Bed Bath & Beyond and then compare them to each other the first thing that we need to do is pull up the latest annual report for Pier 1 in Bed Bath & Beyond your report is also known as a 10k filing and is required by the SEC for all publicly traded companies we can find the annual report for these companies on their company website or on the SE C's website here we have the balance sheet from Pier one which shows the Pier ones fiscal year ends on February 25th of each year we are going to be looking at the amounts reported for fiscal year ending on February 25th 2012 these statements are reported in thousands as you can see Pier one reported total current assets of 650 million three hundred fourteen thousand dollars in total current liabilities of 245 million three hundred eighty eight thousand dollars therefore the current ratio for pure one is a six hundred and fifty million three hundred fourteen thousand dollars divided by two hundred and forty five thousand three hundred and eighty eight dollars the ratio of two point six five here one's current ratio is two point six five this can be expressed in times or in dollars it simply states the pier one has two point six five times current assets as it does current liabilities you could also say that for every dollar the pier 1 has some current liabilities it has two dot sixty-five cents and current assets now let's look at Bed Bath & Beyond balance sheet to calculate their current ratio we also got Bed Bath & Beyond balance sheet from their company website and it is also reported in thousands the first thing that stands out is a Bed Bath to be honest much larger company however they are still both retail stores with a similar focus Bed Bath & Beyond has current assets of four billion one hundred forty two million nine hundred and thirty nine thousand and current liabilities of 1 billion three hundred and thirty nine million one hundred thirty thousand dollars therefore the current ratio of Bed Bath & Beyond is 4 billion wonderful million nine hundred thirty nine thousand / 1 billion 339 million one hundred and thirty thousand the ratio of three point zero nine Bed Bath & Beyond scar ratios three point zero nine which is higher than Pier one's current ratio Bed Bath & Beyond has three dollars and nine cents and current assets for every dollar it has in Current Liabilities according to this Bed Bath & Beyond isn't much better financial shape and is a relatively low risk to both investors and lenders why does Bed Bath & Beyond have a higher current ratio than pure one there could be many factors that we can't figure out by simply looking at the current ratio we would have to look at the history of both companies trends and other ratios before we can come to a conclusion the Bed Bath & Beyond is the better company for example maybe Pier one was on the brink of bankruptcy but has made a huge turnaround this would mean that more than likely the stock is selling at a discount therefore offering you a higher return however it could also mean that pr1 doesn't manage his money as well as Bed Bath & Beyond owes so there's more risk involved another factor could be the Tier one is more aggressive and it's investing maybe it has a lot of investment opportunities which will be good for the investors so it is putting its cash to use instead of sitting on it the point being made here is that just because a company has a higher current ratio does not always mean that it is a better investment there are many weaknesses in the current ratio many of which we have already explained even though a company has a higher current ratio it doesn't always mean us the most liquid this is because as explained before the current ratio includes accounts other than simply cash two companies can have the same current ratio but actually vary greatly in liquidity for example if two companies company a and Company B both had a current ratio of 4.5 except Company A is current assets consisted of mostly cash while company B's current assets consist of mainly inventory and accounts receivable then Company A would be very liquid while Company B might have trouble meeting its obligations especially if it takes them longer to collect on accounts receivable in Company A there are other liquidity ratios such as a quick ratio and the cash ratio that attempt to find a more accurate measure of a company liquidity

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