Join Jim Stice for an in-depth discussion in this video What is financial ratio analysis?, part of Finance for Non-Financial Managers.
- In this section, we will discuss how common, external financial reports are used by those who are standing on the outside of a company and trying to assess the financial viability on the inside of a company. Of course it would be preferable if we could just get inside the company to do our analysis. But companies do not like outsiders poking around on the inside of their company. There's just too much proprietary information that they do not want exposed to outsiders. Things like cost structures, pricing margins, and R and D efforts, to name a few.
We must make do with the information that is available. Another point to keep in mind is that the analysis techniques that we will practice on the external financial statements can be developed and applied within a firm, using proprietary, firm-specific information. In other words, we will practice the techniques on commonly available information and you can develop unique techniques within your company for analyzing firm-specific information. So, let's begin. First of all, let's ask the question: What is financial ratio analysis? We'll begin our discussions by looking at a company most of us are familiar with, Ford Motor Company, the car company.
In 2014, they reported income of $3.2 billion. Is that a lot? At December 31, 2014, they reported total assets of $208.5 billion. Is that a lot, and what'd they do with those assets? At the end of December 2014, they had liabilities of $183.3 billion. Is that a lot? And what did they use that money for? To answer these and other questions, we'll need to carefully analyze Ford's financial statements.
That brings us to financial ratio analysis, which is simply the examination of relationships among financial statement numbers. We're gonna do a lot of dividing one number by another to draw our conclusions. When it comes to ratio analysis, we're going to do two types. One, we're going to compare the same company across time, to see how the company has performed over time. And secondly, at the same point in time, we're going to compare across companies. For example, let's continue with Ford.
In 2014, they had return on sales of 2.2%. Return on sales is simply Net Income divided by Sales, which is a measure of how much profit they earned per dollar. In 2014, 2.2%. In 2013, they had a return on sales of 4.9%. The obvious question, why? How did that happen? Now, comparing Ford to General Motors during 2014, General Motors had a return on sales of 2.6%.
Ford again, 2.2%. Again, why? What has happened to Ford's profitability from 2013 to 2014? And during 2014, why is General Motors more profitable that Ford? Those are good questions and we're going to answer them. Now, when it comes to financial ratio analysis, I like to borrow a quote from Winston Churchill. He said the following: "The further backwards you look, "the further forward you can see." We analyze financial statements to tell us if a company has done well or poorly in the past, and to help us see how the company might do in the future.
When it comes to financial ratio analysis, there's a four-step process. In this course, we're going to introduce you to step one, the DuPont Framework, to break down return on equity into its component parts. So, let's do that next.
- Interpret financial reports and make decisions based on available data
- Manage inventory and receivables
- Create an accurate budget
- Cost a product or service
- Analyze customers
- Understand your income taxes
- Communicate your contribution to the bottom line