Financial statement ratios can tell you a lot about a company when compared to past data or another company. Learn about two key ratios: return on sales and the debt ratio.
- Relationships between financial statement amounts are called financial statement ratios. Net income divided by sales, for example, is a financial statement ratio called return on sales, which tells you how many pennies a profit a company makes on each dollar of sales. - The return on sales for Microsoft is 19.7%, meaning that Microsoft makes approximately $0.20 worth of profit for every dollar of product or service sold. There are hundreds of different financial ratios, each shedding light on a different aspect of the health of a company.
- In analyzing a company's financial statements, merely computing a list of financial ratios is not enough. Most pieces of information are meaningful only when they can be compared with some benchmark. - Knowing that Microsoft's return on sales in 2016 was 19.7% tells you a little, but you can evaluate the ratio value much better if you know that Microsoft's return on sales was 13% in 2015, or that Apple's return on sales for 2016 was 21.1%. - In short, the usefulness of financial ratios is greatly enhanced when they are compared with past values for the same company and with values for other firms in the same industry at the same point in time.
- In this week's video, we are going to share with you two of our favorite financial statement ratios. While there are hundreds of ways to divide one financial statement number by another, these two, and there are a host of others, have kind of stood the test of time and become kind of standards that everyone recognizes as being important. - Now, we've already mentioned that Microsoft makes 19.7 cents a profit on each dollar of sales. This ratio is called the return on sales and, for Microsoft, is computed by dividing net income by sales like this.
- As with all ratios, the return on sales value for Microsoft must be evaluated in light of the appropriate industry. For example, the 2016 return on sales for Microsoft was 19.7%. Comparing this against the return on sales in the supermarket industry, which is frequently between one percent or two percent, does not provide a useful benchmark, because those figures come from outside the industry. - Now, we saw, just a minute ago, that Apple's return on sales was a bit higher than Microsoft's for a comparable time period. We also saw that, compared to the prior period, Microsoft's performance had improved.
- We can now ask the question, why? And we can use common sized income statements to determine what component or components of income were responsible for the difference between Microsoft and Apple in 2016 and between Microsoft 2016 and Microsoft 2015. - Now, to our next ratio, the debt ratio. Comparing the amount of liabilities with the amount of assets indicates the extent to which a company has borrowed money to leverage the owner's investment and increase the size of the company. - One frequently used measure of leverage is the debt ratio, computed as total liabilities divided by total assets.
An intuitive interpretation of the debt ratio is that it represents the portion of borrowed funds used to acquire the company's assets. For Microsoft, the debt ratio was computed and shown here. In other words, Microsoft borrowed 62.8% of the money it needed to buy its assets. Is 62.8% a good or bad debt ratio or is it impossible to tell? - Well, if you're a banker thinking of lending money to Microsoft, you want Microsoft to have a low debt ratio, because a smaller amount of other liabilities increases your chances of being repaid.
- But if you're a Microsoft stockholder, you want a higher debt ratio, because you want the company to add borrowed funds to your investment dollars to expand the business. - So, there's a happy middle ground where the debt ratio is not too high for creditors, but not too low for investors. A general rule of thumb across all industries is that debt ratios will be around 50%. But this benchmark varies widely from one industry to the next. By comparison, Apple's fiscal 2016 debt ratio was 60.1%.
- The takeaway here, dividing one financial statement number by another tells you a little, but comparing the resulting number to the same number for prior years or the same number from another company can tell you a lot.
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