3.2 Asset, Profitability, and Debt Ratios

The next family of ratios we have are asset turnover ratios. So, every business has things they use to conduct their business. And we want to look at the utilization of those assets. If I have stock, how often does that stock turn over? Another asset that I have is accounts receivable. The money that people owes, owe me. That is an asset. How quickly do I collect on my accounts receivable? Things like this. So, asset turn over ratios often times express the ration in the terms of days. Here we’re gong to look at the inventory turnover ratio. Inventory turnover the quick dirty form, is sales divided by inventory. It’s going to give you how many days it takes to sell your inventory. And again, there’s a more complex way to do that. You can use average sales and average days. More complex, but it’s gonna give you a little bit more accuracy. The other one, as I’ve already mentioned, account receivable collection period. How efficient are we in collecting the money that’s owed to us? This one here is average accounts receivable divided by average daily sales. You can do the, just accounts receivable and daily sales, but in most companies, since daily sales can really fuc, fluctuate, you probably wanna use the average on this. Brings us to the next family, the third family of ratios, profitability ratios. We love these. Okay. Now these are a class of financial metrics that help us assess how profitable our business is, the bottom line in the business, how we’re performing. These are near and dear to many people’s hearts as these ones are the ratios that are helping us understand and helping us compare amongst companies the basic financial equation, which is income equals revenue minus cost, right. So here’s the big boy on the block, one, the one that you’re going to hear about all the time, and everybody always brings up. ROE, Return on Equity, and this is Net Income divided by Shareholders Equity. So, what return on equity really tells us is if we look at all the money that owners have paid into the company, or left into the company, the money that’s in there, the equity in the company, and we look at the equity as the generator of income, so what if that’s what’s generating income, and we know there’s other things, but we wanna look at that. Then, how much income was generated by that equity? And, that’s what ROE tells us. So, the higher the ROE, the more that the equity the investment of the owners into that company, is paying off. Next one that’s that’s important is return on assets, right. Why do we have assets? We use assets to generate income, right. So, if we look at instead of looking at equity, right, we look at the assets, let’s look at what we own. How are the assets generating income? Then we have ROA, return on assets, net profit instead of divided by equity for ROE, net profit divided by total assets for ROA. One of the problems with this, right? Well in some businesses, particularly big businesses and old businesses, they probably have some assets that either a, are not listed at their true value today. Remember that $100,000 building? Cuz now, today that building’s worth $5 million. So, it’s generating what a $5 million business could generate, but on the books it’s $100,000 cuz we bought it back in the 1940s. That’s gonna make our ROA look a little bit friendlier than maybe it, it really should be compared to a newer building that only boug, a newer business that only bought their building last year, right. So, there can be issues. Also, sometimes companies have assets that simply are sitting around doing nothing, storerooms full of equipments, supply, just sitting there. Okay. When we use all of our assets, then, of course, we’re getting a little bit of a skewed view. Especially when we compare that to a business. That has as, assets that are fully being utilized. On the other hand, one of the things that ROA can, can show us if it’s too low is maybe we need to offload some of the assets we’re not using. Okay. So again, the, we, we delve deeper into each of these ratios than simply performing the ratio and, and and using the number without thinking it through. The next one is ROI, Return on Investment. Now, ROI is usually used to calculate a gain from an actual investments. Okay, so you put the money in, and you’re getting money out, okay. ROI calculated gain from investment minus the cost of investments divided by the cost of investment, this is your ROI. Okay, so I give you $100 today, next week you give me $110 back. So I take my, my gain from investment a 110, subtract my cost of investment which was 100, and divide that by the cost of investment which is, a 100, and that gives me my ROI. Return on Capital Employed. Remember how I said, on ROA you can have some A? You can have some assets out there that aren’t actually, you know, working or aren’t actually employed. This one breaks that down a little bit further and says look we want to look at the we wanna look at the earnings on the capital that’s actually being employed in this process. Okay. So what this does is we’re gonna look at earnings before interest and tax. Also known as EBIT, and we’re gonna divide that by our capital employed which is assets minus current liabilities. Our next family of ratios are the debt ratios okay as the name implies this is basically how we look at a companies debt what companies owe. And, and in this what we’re really looking at is we’re looking at what we call the financial leverage of a company. How leveraged a company is, is how much how much money they owe. And you would think off the top of your head, you’d think well that no leverage is best. It’s best not to owe anything, right. It’s not really true. Because as we get on, especially the next module, the final module, we look at valuation. We’re gonna start looking at the cost of capital. And we’re gonna see that businesses raise money well in three different ways. One is for profits, for sales, right. The other way is investment. And the third way is from debt. They actually go out and borrow the money. And debt is cheaper than equity. It’s always cheaper to borrow the money than it is to get someone to invest in your company. So if you, you can be overly leveraged and, and really be drowning under the amount of debt you have as a company. But the same time you can not be leveraged enough. You can have to much equity in which you’re paying to much money for your equity. Or you got to much money sitting around in the bank, not generating a lot. And if you went and got some debt, you could, you could expand or grow your business. So there’s really that there’s, there’s a good balance of leveraging that we’re often looking for in a business. So that’s what the debt ratios tell us. And the first of those is actually called the debt ratio, right. Total assets, oh I’m sorry, total debt divided by total assets. Okay. Shows us based on how much we have, how much of that do we owe? Sound familiar, right, like the balance sheet. There’s the Debt-Equity Ratio. This is total liabilities divided by total shareholders’ equity. This is very much like like ROE. But, this is flipping ROE into a debt perspective, okay. Looking at the amount of debt based on the amount of equity we have. So, where are we going more, for money? Are we going to investors or are we going to creditors? Okay. So those are the most commonly used debt ratios. The debt equity ratio and the debt ratio. They’re basically just giving us a view of how much we owe in terms of how much we have in assets, how much we have in equity. And showing us how we’re in leverage. And it’s commonly thought that the best leverage is basically two to one. Now of course this is going to depend on your country, your sector, your environment, et cetera, et cetera. But, a lot of times what most analysts are looking for is about double the debt as the equities. If you have a million dollars in debt to, I’m sorry a million dollars in equity, maybe you want $2 million in debt. Two to one is usually considered ideal. Again, it’s not a cook, cookie cutter format every business is different and depending on your particular environment, the interest w, rates in your country, region, whatever, that might change. The next section we’re gonna talk about a special ratio analysis called the DuPont Pyramid developed by the DuPont Corporation some years back. And this one’s gonna break something down for us, and give us even a better insight into a company. So, we’ll talk about that in just a minute.