**Joseph Ori**,

*CEO, Paramount Capital Corporation*

This course provides a comprehensive review of a company’s business and financial statements using ratio analysis and market based factors.

Ratio analysis is an effective method to analyze and evaluate the liquidity, operations, profitability, capital structure, solvency, management and viability of the business model of a company. Key, liquidity, solvency, profitability and market value ratios are reviewed and discussed. The Dupont equation of the return on equity ratio is analyzed. The Limitations of ratio analysis are also discussed.

### Intro Video Transcript

Welcome everyone. My name is Joseph Ori and I am Executive Managing Director of Paramount Capital Corporation. We're a California based corporate and real estate advisory firm and I'm happy to present the presentation on Corporate Finance Series Analysis of Financial Statements. This is a 31 slide Powerpoint and it is broken up into three sections. Moving on to slide number two, Analysis of Financial Statements. As I said, this presentation is broken down into three modules, each will be approximately 20 minutes each. Participants can view the entire presentation of each module.

Moving on to slide number three. The three primarily financial statements for any company is the income statement balance sheet and statement of cashflows. All are used in ratio analysis. For this presentation we will use the income statement and balance sheet and I have a set of performer income statements and balance sheets from a company that we'll use for the ratio analysis.

Ratio analysis facilitates the comparison of company over time and to industry competitors. Well, the benefit of ratio analysis is that it is very easy to do for one and it is easy to look at a trend of ratios. I prefer doing a 5-year ratio analysis for my company and then comparing my company to competitors and even the leader in the industry and see where your ratios are the same diversion, higher or lower etcetera and you can get an idea of where you stand in relation to your competitors in the industry.

Moving on to slide four, Executive Summary. Ratios are used by one, investors to estimate cash flows and value a company. The profitability ratios that we will be looking at have various ratios to estimate the net profit margin and close profit margin, price earnings ratio and other metrics to valuate company and this is very important and this is what is typically used in Corporate finance, Corporate America and Wall Street to value a company. Managers also use ratios to monitor performance and identify strength and weaknesses of their company.

Ratios are very important for this fact. Any CFO or Senior Executive in a company should have on his computer dashboard a set of ratios for his company and those should be updated at least monthly, maybe quarterly and compared to the industry and see where the trends are. Are you going up and down, is your gross profit margin going up or down, what's happening with your competitor gross profit margin and other ratios. Third, ratios are used by lenders and bond holders to determine the creditworthiness of a company.

Some of the ratios like debt ratios and others are used by lenders to determine, are you going to be able to pay back the money we lent you and is there enough cashflow to cover our interest expense, and the time interest earned and the debt ratio are key ratios that lenders and bond holders will look to for companies.

Slide five, ratios are also used by competitors to benchmark against the industry leaders. As we have said before as an operating company you have to compare your company to others in the industry and one of the best ways to do that is to do a ratio analysis, again preferably over five years so you can see a trend of all the ratios are going up or down and their relation to competitors in the industry. Next, ratio analysis has limitations and qualitative factors need to be considered. Like anything in Corporate Finance ratio analysis has some limitations. In addition to ratio analysis you have to apply some qualitative factors in analyzing a company and we're going to discuss what those are in the third module of this presentation.

All right, let's go on to slide six. Here's our Ratio Summary and let's talk about the first set of ratios, these are called liquidity ratios and these ratios answer the question, can the company meet its short term liquidity needs? The first ratio, liquidity ratio is the Current Ratio. The current ratio is current assets divided by current liabilities.

Now in the current ratio the numerator is current assets and the denominator is current liabilities. The three current assets are typically cash and marketable securities or investments, counts receivable and inventory. The three primary current liabilities are accounts payable, COD liabilities and notes payable. This ratio then says, does the company have enough current assets to pay its current liabilities, and that's a key ratio for liquidity purposes, the current ratio.

The next ratio, liquidity ratio is the Acid Test or Quick Ratio. The Acid Test or Quick Ratio is similar to the current ratio except inventory is subtracted from the numerator, so the ratio is current assets minus inventory divided by current liabilities. Why did they subtract inventory from the numerator? Well, typically inventory is the slower moving current asset especially if tied inventory and therefore this gives a better and more precise measure of liquidity for a company, and therefore the inventory is subtracted from the numerator.

Obviously, the Acid Test or Quick Ratio will always be less than the current ratio just from the fact that the numerator is smaller. This ratio, the Acid Test, is also looked at along with the current ratio by lenders. Anybody who makes a long to your company will look at these ratios over a period of time, three to five years, to make sure you have enough liquidity cash on your balance sheet in other securities to pay back their loan.

The third liquidity ratio is called Accounts Receivable Turnover. Accounts Receivable Turnover is Sales divided by Accounts Receivable. This determines how quick a company is getting paid cash is coming in the door from its receivables and this is a key liquidity ratio. Any company that's in the merchandising business trade, selling almost any product, Accounts Receivable Turnover is key. The higher the better, the higher the turnover the better.

If your Accounts Receivable Turnover is three or four times a year, that is very detrimental compare to a company that's turnover is 10 or 15 times a year. That means you're not getting paid fast enough on your Accounts Receivable and you need cash coming in the door from Accounts Receivable to pay your operating expenses, buy new inventory and keep the cycle going.

Let's go on to slide seven. The next liquidity ratio is called Days Receivable. Days Receivable is 365 divided by the Accounts Receivable Turnover we just talked about and this gives you the turnover in days. The higher the Accounts Receivable Turnover the better, the lower the days receivable the better. If your Accounts Receivable is 10, your turnover is 10 and your days receivable is 36.5 days. However, if your Accounts Receivable Turnover is 20 then your account Days Receivable is 18 which is a lot better turnover than 36 days that means you have cash coming in every 18 days instead of every 36 days.

Next liquidity ratio is Inventory Turnover. Inventory Turnover is Cost of Good Sold divided by Inventory. If everybody remembers your counting, Cost of Good Sold is beginning inventory plus purchases minus ending inventory equals Cost of Good Sold. Cost of Good Sold is an expense on the income statement and if you take Cost of Good Sold divided by Inventory you will see how fast your inventory is turning over, and again as in Accounts Receivable Turnover the higher the Inventory Turnover the better.

That means your product is moving out of your store or your operation fast enough to replenish your inventory and bring more cash into your business. The next ratio is the Days Inventory. The Days Inventory is 365 divided by the Inventory Turnover we just talked about above, and again the lower the Days Inventory the better. The higher the Inventory Turnover the better. Again, if your Inventory Turnover is 10, your days inventory is 36, that means your inventory is moving out of your operation every 36 days.

However, if your Inventory Turnover is 20, that means your days inventory is 18 and that is a lot quicker turn of your inventory. When the biggest problems companies had that have that sell product and have inventory is they don't monitor their inventory and the inventory doesn't turnover fast enough. Remember, when you have inventory you have to purchase it so there's a cost here. You have to get it shipped to your stores or your operation, that's the cost. You have to hold it in your warehouse or in your stores, that's a cost. So the longer inventory sits without being sold, the higher the cost use company. A lot of small companies especially their biggest problem is Inventory Turnover issues.

Okay. let's move on to Slide eight. Let's talk about Solvency Ratios. Solvency Ratios answer the question how leveraged is the company and can it meet its debt service requirements? The first Solvency Ratio is the Debt Ratio. The Debt Ratio is total liabilities divided by Total assets. This is a key ratio for lenders, both of these ratios, Debt Ratio and the Time Interest Earned. The Debt Ratio says how much of your capital structure is comprised of liabilities?

If your Debt Ratio is 40% that means your stockholders equity or the equity invest in your company is 60%. So it's a key ratio for any company. You can also compute the Debt Ratio as follows: long-term debt divided by total assets. You can just look at your long-term Debt exposure instead of total liabilities and that is also an important ratio regarding solvency for companies. The next ratio is Time Interest Earned or Interest Coverage. This is a key ratio for lenders and bondholders. Time Interest Earned or Interest Coverage is something called EBIT divided by Interest Expense.

EBIT is Earnings Before Interest and Taxes or income before interest and taxes. This is a key metric, as I said, that lenders and banks and bondholders will look at. Most banks and even bondholders in their loan agreement they will have a Time Interest Earned covered in in there and the cabinet will say something like the company must maintain a Time Interest Earned ratio of at least 81 during the term of this loan and typically if you preach that coverage, then your interest rate goes up by 25 basis points or 50 basis points or something like that. So Time Interest Earned and Interest Coverage again very important ratio for lenders and bondholders.

Let's go on to slide nine. Let's talk about Profitability Ratios. These ratios ask the question, what is the company earning on its sales, assets and equity? Basically how profitable is the company. The first profitability ratio is the Gross Profit Margin. This is a key ratio of metric in Corporate Finance and it's defined as the Gross Profit of a company divided by Sales. This shows what percent is the company earning above its Cost of Good Sold in regards to its sales.

Depending on the industry, most Gross Profits could be somewhere with 35, 45 maybe even 50% just depends on the business, the product and the industry. This is a key metric in Wall Street. Companies when they report their earnings and their Gross Margin equals profitable percentages down for the quarter. Their stock typically gets hit one or two points. This is such a key metric because if your Gross Profit Margin goes down, the investors are saying "Well, hey, what's the matter?" The company's got pricing problems, they can't get the price on their products or their cost went up or both.

The next Profitability Ratio similar to Gross Profit Margin is Net Profit Margin. Net Profit Margin is the Net Income divided by Sales. This is also a key ratio in Corporate Finance and in Wall Street. The how much company is earning on its sales, the company's Net Income over Sales is very key and obviously the higher the better. Most Profitable companies have Net Profit Margins in the double digits 12, 15, some even 20%, some even higher than that, 25%. A lot of it depends on your product type, for example a safeway, a grocery store has a Net Profit Margin of 2 or 3% while an Apple or a software company has a Net Profit Margin of 20%. So a lot of it depends on your industry, but again this is a key ratio for analysis the Net Profit Margin.

The next ratio, Profitability Ratio is Return on Assets. Return on Assets is defined as Net Income divided by Assets. This ratio asks, what is the company earning on early investments that has in its various assets, and this is also a good ratio to compare to other companies in the industry especially over a 5-year period. See how profitable the company is in using its assets.

Moving on to slide ten. The nest Profitability Ratio is Asset Turnover. This is defined as Sales divided by Assets. This ratio shows how much is a company earning in sales for its investment and its assets, and obviously the higher the better, and so Asset Turnover along with Return on Assets are two asset ratios that are critical for companies.

The last Profitability Ratio and the most important is the Return on Equity. This is probably the most important ratio for a company and it is Net Income divided by Stockholders Equity. The Return on Equity is key because it tells the user, investor, management what return are we earning on our stockholders equity. If you are a equity investor and you go out and buy a stock the return on equity should mirror the return expected on holding that stock. It's not always going to be the same obviously but that is what this ratio is telling you, and very profitable companies that are one have good cost structures, have high returns on equity.

A good Return on Equity is over 15%, a great one is over 20%, anything over 25% is tremendous. Very few companies earn Returns on Equity over 25% especially for a long period of time. Lot of small companies can do it for two or three years but then the return starts regarding more to the mean. So Return on Equity is a key ratio in corporate Finance and should definitely be calculated for your company and compared to your competitors.

The last ratios we're going to look are Market Value Ratios. These ratios ask the question, how is the market valuing our company? The first one is the Price Earnings Ratio and that equals to Stock Price divided by the Earnings Per Share. This is a key ratio in Wall street and Corporate Finance. Every analyst, every investor looks at the Price Earnings or PE ratio. Many companies have very high PE ratios. This normally means that the market has pushed up their stock price so high assuming that there's going to be huge growth in the future that they have a very high PE ratio.

Companies that have high PE ratios today: Netflix, Amazon and number of other ones. So it depends on what type of business you're in and what the outlook is for your company. There's also a number of company that have low PE ratio General Motors, some of the big manufacturers, Verizon, AT&T, the over companies have lot of cash flow have lower Price Earnings Ratios. Another Market Value Ratio is Market to Book Value. This is the Stock Price divided by the Book Value Per Share. The Book Value Per Share are the assets on the books minus the liabilities divided by the number of shares. That amount is then divided into the Stock Price to see what the relationship is between the market price of the stock to the book value and this is also an important ratio to see and compare to other companies in your industry.

## Learning Objectives

- Acquire the ability to use ratio analysis to analyze corporate financial statements.
- Acquire the ability to calculate key liquidity, solvency and profitability ratios.
- Acquire the ability to benchmark company ratios against competitors.
- Use trend analysis to compare ratios over time

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## Prerequisites

**Course Complexity:**Foundational

A basic understating of corporation finance and the four financial statements.