From the course: Financial Accounting Part 2

Ratio analysis

From the course: Financial Accounting Part 2

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Ratio analysis

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- 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 structure, 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 2017, they reported income of $7.6 billion. Is that a lot? At December 31st, 2017 they reported total assets of $258 billion. Is that a lot? And what they do with those assets? At the end of December, 2017, they had liabilities of $229 billion. Is that a lot? And what 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 going to do a lot of dividing one number by another number to draw our conclusions. So, let's continue with Ford. In 2017, they had return on sales of 4.9%. Return on sales is simply net income divided by sales which is the measure of how much profit they earned per dollar. And 2017, 4.9%. In 2016, they had return on sales of 3%. The obvious question, why? How did that happen? How to explain the increase from 3% to 4.9%. Now comparing Ford to General Motors during 2017, General Motors had a return on sales of 0.2%. Recall that Ford reported a return on sales of 4.9%. Again, why? What has happened to Ford's profitability from 2016 to 2017? And during 2017, why is Ford so much more profitable than General Motors? These 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. So, when it comes to financial ratio analysis, let's begin with the return on equity. This ratio will lead us into the DuPont framework, the most clever chaining together of ratios, I have ever seen.

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