From the course: Finance for Non-Financial Managers

What is financial ratio analysis?

From the course: Finance for Non-Financial Managers

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What is financial ratio analysis?

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- You can get a lot of information just by doing a simple thing. Divide one accounting number by another. - The results of these calculations are called financial ratios. - When it comes to financial ratio analysis, I like to borrow a quote from Winston Churchill. He said the following, "The farther backward you look, the farther 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. - 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. - [Instructor] There's just too much proprietary information that they do not want exposed to outsiders. Things like cost structures, pricing margins, and R&D efforts to name a few. - So we must make do with the information that's 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'll 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. - [Instructor] Let's look at a company with which most of us are familiar, Walmart. - [Instructor 2] In 2022, Walmart reported net income of $11.3 billion. Is that a lot? - [Instructor] At the end of 2022, Walmart reported total assets of $243.2 billion. Is that a lot? And how efficiently did Walmart use those assets? - [Instructor 2] At the end of 2022, Walmart had liabilities of $159.4 billion. Is that a lot? Too much, too little? - To answer these and other questions, we need to carefully analyze Walmart's financial statements. - [Instructor 2] That brings us to financial ratio analysis, which is simply the examination of relationships among financial statement numbers. - We're going to do a lot of dividing one number by another to draw our conclusions, but don't worry, we'll do the arithmetic and you can just help us interpret the results. - When it comes to financial ratio analysis, we're going to do two types of analysis. First, we're going to compare the same company for several years to see how the company has performed over time. - And second, at the same point in time, we're going to compare across companies in the same industry. - [Instructor 2] For example, let's continue with Walmart. In 2022, Walmart had return on sales of 1.8%. Return on sales is simply net income divided by sales, which is a measure of how much profit Walmart earned per dollar. - [Instructor] In 2022, return on sales was 1.8%. The year before, in 2021, Walmart had a return on sales of 2.4%. The obvious question is this, why did the return on sales go down from 2021 to 2022? - [Instructor 2] And let's also think about this. Let's compare Walmart to Target during 2022. Target had a return on sales of 2.5%. - [Instructor] In 2022, why was Walmart's return on sales of 1.8% so much lower than Target's return on sales of 2.5%? - So we have two questions with respect to Walmart's 2022 return on sales. Why did it go down from 2021 to 2022? And why is it lower than Target's? - These are good questions, and in the following modules, we're going to do some simple analysis to identify some possible answers.

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