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Important Ratios in Financial Forecasting

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  • 0:02 Financial Ratios
  • 1:05 Ratio Considerations
  • 1:56 Profitability Ratios
  • 3:38 Debt Ratios
  • 4:26 Investment Ratios
  • 5:33 Lesson Summary
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Lesson Transcript
Instructor: Anthony Aparicio

Tony taught Business and Aeronautics courses for eight years; he holds a Master's degree in Management and is completing a PhD in Organizational Psychology

Financial ratios are a quick way to review a company's financial performance and compare it with others. This lesson will review a few select financial ratios to show how they are developed and how they can be used to forecast future performance.

Financial Ratios

If you've ever looked at the financial section of a company's annual report or popular financial websites, you probably noticed a lot of acronyms like EPS, ROA, ROE, and P/E. Each of these is a different ratio that gives specific information about how the company is performing. They look at things like profitability, the use of assets, the ability to pay debts, or how well the company pays stockholders dividends. Depending on your investment strategy, you'll be concerned with different ratios. This lesson assumes that you already have a basic knowledge of terms found on common balance sheets and income statements.

It's important to note that these ratio values can vary widely depending on the industry and size of the company; they therefore have little meaning by themselves. In order for the ratio to provide you with valuable information for forecasting, you'll have to compare the ratio to something else, such as the same ratio for the same company in prior years or their competition's ratio during the same periods.

Ratio Considerations

The type of industry is very important when looking at the value of a ratio. A service-related industry, such as a web-based search engine like Google or Yahoo, etc., will have a totally different amount and use of assets than a manufacturing company like Dell or Dodge. When you're using each ratio, there will be a specific range that usually applies to the given industry.

There are many other considerations to take into account, including different methods of accounting allowed under generally accepted accounting principles (GAAP), recent changes in company focus, changes in leadership, updates to tax laws, increase or decrease in competition, or corporate restructuring. Any of these will have a temporary impact on the company's ratios, so be sure to look for trends over multiple years and take other factors into account.

Profitability Ratios

There are many profitability ratios, but the one we'll focus on here that is commonly used in forecasting is return on equity (ROE). ROE is found by taking the net income for the company and dividing it by the average stockholders' equity. The average stockholders' equity can be found by adding the stockholders' equity from the end of the current year and the beginning of the current year and dividing by two. This ratio provides investors and researchers with the amount of return (increase) that has been earned by using the stockholders' investments.

Let's give it a try. What would be the ROE of Profits, Inc., which began the year with $2.5M in shareholder equity, ended that year with $2.7M, and earned a net income for that period of $350,000?

ROE shows profit percentage made from investments:

$350,000 / (($2,700,000 + $2,500,000) / 2) = $350,000 / $2,600,000 = 13.46%

Another common profitability ratio is return on assets (ROA). ROA attempts to analyze how well a company is using their assets to make profits. This ratio will show a big difference between a company that focuses their purchases on things that make the company (and investors) more money (such as equipment) as opposed to spending on things that may look good (like a fancy new office building) but do nothing to generate revenue. ROA is found by taking net income and dividing by average total assets. Average total assets can be found in the same way we used to find the average stockholders' equity in the ROE ratio.

Armed with this knowledge, what would be the ROA for Profits, Inc. if they had average total assets for the year of $3.1M?

ROA measures efficient use of assets:

Net income / Average total assets = $350,000 / $3,100,000 = 11.29%

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