After watching this video lesson, you will understand how financial ratios are calculated. You will also understand where they come from and how to read them.
Meet Joe. He is a business owner. He owns the local burger place. He makes the best cheeseburgers and fries you have ever known. I mean, his stuff is so good that he has a line out the door no matter what time it is.
Joe, though, being the businessman that he is, not only does the food well, he also takes care of his finances well. Because he is in business, he also understands how important math skills are. He even took a refresher math course just so he can keep his finances in good order. See, what Joe does with his finances is he calculates his financial ratios. These are ratios of important numbers from his financial records. Joe is able to tell how his company is performing by looking at these ratios.
Some examples of the important numbers that he deals with are net profit (how much profit Joe ends up with), net sales (how much sales Joe ends up with), total liabilities (all of Joe's debts), and total assets (how much money Joe's business is worth). Let's see how Joe makes his calculations.
To calculate any financial ratio, we take one of our numbers and divide by the other number. Which numbers we choose to use depends on what we want to analyze. If we want to analyze our profit margin, how much of our sales is actual profit, then we would want to divide our net profit by our net sales. This will give us a decimal number, which we can turn into a percentage that will be easy to read and understand. We will look into Joe's profit margin in just a bit.
Another example is the debt ratio, which tells us how much the company is in debt. To calculate this financial ratio, we need to divide our total liabilities by our total assets. This time, again, we will also get a decimal number, which we can turn into a percentage. We will also see Joe's debt ratio in a bit, too.
But first, let's see how Joe calculates his profit margin.
Do you remember how to calculate the profit margin? We divide our net profit by our net sales. For Joe, he looks through his financial records and he finds that for this past month, his net profit is $20,000, while his net sales are $60,000.
Following the formula for calculating the profit margin, he takes the net profit and he divides it by the net sales. He gets $20,000/$60,000 = 0.333333. Joe gets a decimal answer. Turning this into a percentage, he gets 33.33%.
Looking at this percentage tells Joe that about 33% of his sales ends up being profit for him. This means that he has room to give out coupons and still cover all his costs and expenses. The higher the profit margin, the better it is for the business. It allows the business to take this profit, this extra money, and put it back into the business so it can grow.
Now, let's take a look at Joe's debt ratio. See, Joe does have some debt. He took out a loan so he could start his burger place. He also took out a loan to buy a food truck so he could take his burgers out on the road and to special events.
Do you remember the two numbers that Joe needs to calculate his debt ratio? He needs to divide his total liabilities by his total assets. Again, Joe looks to his financial records. He finds that right now, his total liabilities amount to $150,000, while his total assets amount to $500,000. He divides these two numbers to find $150,000/$500,000 = 0.3. He gets a decimal. Turning this into a percentage, he gets 30% for his debt ratio.
Joe looks at this percentage and isn't too pleased. He wishes it were lower. That 30% means that 30% of everything he owns is actually debt. This 30% debt means that someone else can take 30% of his company if he isn't able to pay it off.
As you can see, these financial ratios are pretty important. They help Joe understand his business more and allow him to make wise business decisions so that his company can move forward and grow.
So, what did we learn? We learned that financial ratios are ratios of important numbers from financial records. Financial ratios help business owners get a better understanding of how their business is doing. They are calculated by dividing one important number by another.
Which numbers are used is dependent on what kind of information is needed. For example, to calculate the profit margin financial ratio, the net profit is divided by net sales. To calculate the debt ratio financial ratio, the total liabilities is divided by the total assets.
These ratios will give you a decimal number, which you can turn into a percentage to give you an idea of how your business is doing. The profit margin tells you what percentage of your sales is profit, while the debt ratio tells you what percentage of what you own is debt.
After reviewing this lesson, you should have the ability to:
- Define financial ratios
- Identify the importance of financial ratios
- Explain how to calculate the profit margin and and debt ratio