 Well, hello everyone and welcome back to Sailor Academy's MBA 601 We're gonna be talking about unit two today if you haven't seen our previous two unit one videos They should be in a playlist below and of course this is all about Sailor Academy's course So it's important that you check out the course to get the full details of what's going on here But I'm just gonna go ahead. I'm feeling good this morning. I'm just gonna go ahead and hand it over to Dr. First of all to get us going. Great. Thanks Michael and hello again We will be talking about unit two in the financial course in our MBA program here at the Sailor Academy if you recall the our seven units in this course and In the first two presentations in this series we discussed managerial accounting and financial accounting and the implications of both We want to turn now to Doing a deeper dive into the financial statements and particularly how we can use those to analyze Information as you saw from prior Presentations there's a lot of detail in those statements. We want to spend a little bit of time talking exactly what we do with it Now we had discussed that each of our courses has certain learning objectives For unit two the two that apply here are one the ability to explain the financial package Including all the different statements in it. We went into some detail on that in the last last lecture And more particularly paid the ability to apply apply the results that we have To conduct an analysis and more importantly to use analysis. What's the purpose of doing all of the math that I'm going to Share with you today In particular for this unit two our learning objectives are going to be the ability to calculate various financial ratios Now we're going to see that there are a number of them Now we're not going to go over all the potential financial ratios. We'll highlight a few Key and commonly used ratios So that you get a sense the good news is there is tons of information and in our course We provide access to lots more material and Ratios that you can gain from the financial package. We'll talk specifically about the evaluation process Evaluating the firm's performance both over time and also Importantly how we stack up against other players in the industry whatever industry silo we happen to be in and Recognizing areas where we can we're not meeting Expectations we're not being the budget of the forecast or there's simply areas where there's opportunities for performance improvements Now in in topic two in unit two we have a number of topics that were covered Common sizing is something we talked about in the last presentation and we had examples and demonstrated that basically it was taking the financial statements and restating those as ratios Showing for example costs of goods sold as a percent of sales so that we could get a better sense of Direction and performance Well, we're going to get into very specific ratios today. We're going to talk about Profitability ratios profit is certainly a key component of every business and so we spent a lot of time focused on profit Want to talk about liquidity and operating ratios will also talk about debt Most businesses will carry some degree of debt or leverage to maintain their operations. So let's take a look at those ratios Market value ratios. This is really an indication of how well the firm is performing at least in in the In the eyes of the outside marketplace and then we'll talk a little bit about compared to financial analysis and Trend analysis and benchmarking Now before we dig in and start calculating ratios, let me just take a moment here and see if anybody has any immediate questions Great. Thank you All right, let's look at the the whole concept of financial statement analysis We talked about the fact that we typically what when I got and received the financial statements they quarterly And on an annual basis one of the first things I looked at were the common size statements again That simple calculation of showing each item on the statements as a percent For example on the income statement the revenue line By analyzing these statements we can hope to get a much better understanding of exactly what this firm is doing in terms of Generating profit we hope Where what is their status on liquidity and what about the Controlling the operations which consume a lot of time and resources in most operations And when I talk about how these ratios help us to make decisions One of the key rot responsibilities of management is deciding deciding things on product offerings on costs and the use of resources so we're going to find that we can go into these statements and Determine an awful lot about how our business is doing. So let's let's start with profitability Now just to make it a tad more complex We're not going to talk just about net profit net profit. Of course is the bottom line Alright, so if you look at an income statement, you could take the revenue on the top total income subtract all the expenses including any taxes and you wind up with Earnings or the net profit at the at the end of the statement Well, we're going to take that statement We're going to break it into a couple of component parts because we're going to see that there's some some Implications here in the decisions management is making and its impact on that bottom line So let's start with the idea of gross margin Now gross margin is going to take a look at gross profit. So let me go back and remind everybody that on the income statement We start with the top line, which is income The first thing we take out of income was the cost of good sold or CAGS That basically is the materials and labor that the business is used to produce the products that are being sold the difference between the revenue and CAGS is The gross margin now what we want to do is just like in common sizing We want to turn that into a percentage. All right, so we know for example That in the I applied some numbers here to make these ratios a little easier to understand We can see that our One million two hundred thirty six thousand dollars our revenue was seven million. Okay, so We can see that there was a dollar amount of profit generated In the firm, but what is that as a percent so I can start comparing it to? Future performance past performance and even outside our industry our gross margin Which is the gross profit divided by revenue and we're going to multiply that by a hundred so that we can generate a percent All right, and that's seventeen point six percent Again for comparison purposes. I put some numbers up there and said last year Let's suppose our profit our gross margin was fourteen point six percent. So what's it tell us one? It tells us our gross margin has improved. It's gone up a bit meaning. We are in fact more profitable Specifically what is the seventeen point six percent mean think of it this way for every one hundred dollars that we generated in revenue We spent eighty two dollars and four cents on cost of good soul Which left us with a gross margin of $17 and sixty cents Now is that good bad indifferent the answer is I don't know We'd have to see what was the plan What was our target for a gross margin at this point in time if it was less than seventeen point six percent Then we've at least exceeded our target. I don't know if that means it's a spectacular performance yet There's a lot more analysis to do but at least we're starting to think about what's happening now more important I said that we use these ratios for decision-making. Well, what decisions can we make? In a very simple level Suppose that you're looking at the seventeen point six percent and saying, you know, we really were looking or shooting for a target of 25% Well, there's two things that you can do here one keep costs the same in increase sales or to You can read you reduce the costs Right. And so perhaps is that decision-making process? This might be one of those things they'd make a note of and say well Obviously the cost of good soul is still too high To generate the profit target the gross margin target. I'm looking for so Let's consider some things that we can do to have an impact on that cost of good soul Remember I said that they comprise of two basic components materials and labor Well, could we get together with the purchasing operation and see about initiating a project to locate additional suppliers? Negotiate prices to a lower cost consider things like quantity discounts and Are we being a careful steward of the use of the human resources? What does our what is what does it look like for the number of people we have working in the operation? Are we heavy in that areas that are an opportunity to become more effective with training? The employees make it make them more effective more efficient thereby produce more lowering the overall cost All right, so if you're getting the idea that we can do a Simple ratio and then turn that into a substantial meeting. You're right. That's exactly what we do with this analysis But let's not stop with just a gross margin. Remember, we're only two lines down on the income statement. So let's go to the operating margin the operating margin is the margin that comes below the what we just talked about When I we talked about the gross margin number gross margin is revenue minus cost of good soul Now what we want to do is we want to go below that line and take out additional expenses typically SG and a all right sales general operating expenses and Administration and that's going to give us what our operating margin is now. This has not taken us to the bottom line yet All right, but we're almost there. So what's our operating margin in this case again? We're going to look at EBIT and if you recall from our lectures in For unit one EBIT is the earnings before we pay any interest or taxes All right So it's all the expenses except for interest on debt and taxes that are due and we're going to divide that by revenue Multiply by a hundred and we find our operating margin is seven point one percent Now last year. Let's assume it was point three percent very low So on one hand Significant improvement at least against last year. I don't know what that shows yet for the market We haven't gone outside the doors yet. We're still looking internally But what does that mean? It means that for every hundred dollars of revenue that were generated from the sales of products and services There was ninety two dollars and ninety cents spent on expenses Those expenses now include costs of goods sold plus SG&A and what did that leave the firm? It left us seven dollars and ten cents in operating margin. Now again an improvement over last year We probably would go back a look at the past few years. We'll talk about that more Later in this presentation What you're starting to get the idea again if the seven point one percent is lower than expectation Well, we've got a place to start to look and it probably would be going through the detail Expenses that are listed under SG&A The selling expense the cost of administration marketing programs and other operating costs Let's take a look at those and remember in terms of a business one thing that I that I found over being in business many many years is that we continually focus on cost management I don't know after 30 years in business as an executive but for any time I said, you know what we're really good Don't worry about cost go ahead. We always concentrate on evaluating costs Just to ensure that there aren't opportunities to have a direct positive improvement and the results of the firm All right, so that's the operating margin And now let's get to the big one, which is the bottom line the net profit The net profit is the last item on the income statement So after revenue taking out all expenses this time including any interest payments we make And any taxes that are due that's the net profit also referred to as earnings All right, that's the bottom line Our net profit margin for the current year is 3.6 percent Last year was a negative 1.6 Now I'm showing negative numbers for the prior year so that we look at this and say well, we've improved but As an executive i'm here to tell you that because we did better than the year before Doesn't mean that we are either meeting expectations or actually achieving all that we should One thing that I mentioned Probably more often than anybody wanted to hear in an executive review meeting was I know what the number is My question is what should it have been? And that's a much harder question to answer What should the margin have been? based on The economy the marketplace competition our products and services So but it's a question that that we should spend some time on if we're really going to be effective and efficient at managing our businesses Now the 3.6 percent net profit margin here Means that for every dollar of revenue that we generated by selling our products and services We received about four cents in bottom line in the net profit margin Now that sounds like a small amount But if you're talking about millions or tens of millions or hundreds of millions of dollars that can be substantial But again Is is that sufficient for what we're trying to do is if sufficient for the firm for our investors and for our shareholders Okay Now what I want to do is go to another Some rush analysis and we're going to look at liquidity now if you remember from our presentation last week Talked about liquidity meaning how liquid is the firm liquidity is the firm's ability to Put their hands on cash to meet obligations or operating expenses that come up Uh, we looked at the remember we looked at the balance sheet Which is where these ratios are going to come from so now from the income statement. We're going to go to the balance sheet Assets are things that the firm owns they have value All right, there were something but remember that we divided that balance sheet into two parts We had current assets We had non current The current assets were those that we could reasonably expect to turn into cash within the next 12 months so that's liquidity and Certainly suppliers and creditors are going to be interested in exactly how liquid the firm is in other words, what position are you in to be able to Access cash to meet certain obligations that the business has Now we're going to look at at two liquidity ratios for our purposes today We're going to talk about the current ratio, which is sometimes known as the capital ratio And we're going to look at the quick ratio Now remember working capital That's the amount of money that the firm has that they can use in the day to day operations of the firm So let's look at the current ratio Current because we're going to look at current assets Now we're not looking at the long term assets because they're long term. They're not very liquid It could be years in order to convert plant and equipment for example into cash So let's take a look at current assets versus our current liabilities And remember that current liabilities are those liabilities, which are going to need to be paid in the next 12 months So current assets current liabilities In this case our current ratio is 2.58 Last year that current ratio was 1.46. Is that good or bad? Well, let's make sure we understand what it means A current ratio of 2.58 means that for every dollar of liabilities The firm has $2.58 in assets that can be used to cover those liabilities Now here's the interesting thing Obviously the higher the number the higher the current ratio The better the firm is able to cover any liabilities they have However, if that number gets too high, it's not good for the business Why is that so let me confuse you a bit more If that number is too high It means that you've got lots of money tied up in assets And remember the first purpose of the firm investors owners Shareholders put money into the company. They gave you money so that you would invest it to increase their return If we're sitting on too many assets and perhaps not generating a big enough return That isn't necessarily a good thing And that's why we monitor and we look at these ratios and we keep asking ourselves the question Is is this good? Does it need to be improved? Does it require additional attention from us? Now last year I said it was 1.46 So we've obviously made some improvements In either lowering our liabilities or increasing our assets Again, the final question are our current assets Working for us and we're we're going to talk about that in just a few more slides The other is the quick ratio now. This is an interesting one because what this says is we want to take that the current assets that we just use But we want to take out the inventories Now remember when we reviewed the balance sheet in the in the last lecture We said that inventory is an asset. It's it's a it's a product ready to be sold. It has value to the company but does it The question on ask an inventory that Particularly lender will ask is how liquid is that inventory? Is that inventory that's turning on a regular basis? We're selling it every day every week every month or do I have an excess amount of inventory that may have been sitting in stock for an extended period of time? Perhaps even approaching the point of being obsolete At some point we'll we have to write off some of this inventory So oftentimes what investors and lenders will look at is the quick ratio Which says let's take a look at the assets against liabilities, but pull those pull the inventory out of there We're going to do a more deep dive in the inventory, but for our purposes right now take it out And now we see that the current the quick ratio for the current year is 0.93 So you can see it drops substantially. So immediately that tells us what? It tells us that inventory was a big part of current assets Again, not necessarily bad. It probably where we acquired an analysis of the inventory to determine exactly how liquid it is How viable is that inventory? So so the important thing here is just to recognize that while again inventory are positive is something we own It depends it depends on the value of that inventory Now if I've made sense so far and we've gone over a bunch of ratios Let's just take another minute and see if that's generated any questions so far And I can't hear you Michael. Can you hear me now? I can a thousand apologies. I'll say everything quick again Leave a thing in the chat or a comment. Uh, can we go back to the um, um, I think the operating page real quick When you had 7.1 could you just go over that line again? Uh 7.1 for I think it was the operations page Yeah, right here. Could could you just get the operating margin? Could you just go over the the second line again? I think you just cut out and I just I didn't hear anyway The the formula that got you to 7.1, but I heard everything else operating margin is going to That's the the margin that is after we've we've considered the uh, we've taken out cogs and and um, Looked at that. We're going to go to the next line where we're going to take out cogs and s gna Uh, so the the formula here is ebit which is earnings before interest in taxes So that's all the expenses cogs and s gna, but we haven't paid out any interest or taxes yet And so that percent is 7.1 and it's going to be uh, The only thing left to take out at this point will be the interest in the taxes which we'll do in the net profit market Awesome. Thanks. And uh, I I haven't seen any questions coming in so I think we can move on But again, if anyone has any other questions, uh, feel free to leave them In in the chat or in a comment and I will uh, I'll get out of here great Okay, so um, let's get right back into ratios because I know you're excited to use your calculators again And let's talk about operating ratios note that I I've mentioned a couple times um, the importance of What kind of return we're generating? um As a former president ceo of uh, of a publicly traded corporation I recognize the impact my decisions can have on generating returns for shareholders and owners of the business We take the money and we spend it. What do we spend it on? We make investments. We invest in equipment We invest in products we invest in people and why do we do that? Because we want to generate an acceptable return So in operating ratios, we want to look at while there are many more when I look at two key ratios that are of keen importance to owners shareholders lenders and and even suppliers And that is return on total assets the ROA and the return on equity So let's talk about return on assets again. Remember assets are things that we own Why do we own them because we bought them? We invested money And what are the assets that the firm has if you go back to the balance sheet? Excuse me We have cash We have receivables. We've made sales and we're waiting for money to come in we have inventory So we've invested in assets Um, and now we're talking about total assets not current assets. So let's also include plant and equipment Facilities the equipment we use in production all of those have been purchased We've made investments in those why to generate an return And so one thing that shareholders will be keenly interested in is what is the return on those assets that we invested in So we're going to take in this case the net income We're going to divide that net income by the total amount of assets Multiply that by a hundred to generate a percentage And we see that in the current year our return on assets is 7.2 percent now Note that that is way up from last year, which was a negative return In other words for all the assets we had in place last year We had a negative return on the application and use of those assets in the business Now we're starting to be positive at 7.2 or That every dollar invested in assets is generating a return of about seven cents now Could be good Maybe not so good. It's an improvement over last year But are we on target for what our expectations were? Remember one of the big things that management does at the beginning of the year is we put together the plan The strategic plan for the business and part of that plan is forecasted and projected financial pro pro formas We forecasted What these what these returns would be? And so the first thing I want to look at internally is For now for the current year 7.2 percent. How does that match up against what we budgeted? If we had budgeted Say five percent bringing it up from a negative three then we have met and exceeded the budget But if we had budgeted 15 percent We're way off and again the first initial part of every discussion on this would be why Why is the return on assets 7.2 percent? And assuming that one thing I'm always going to look to do Is improve performance? What can I do to ensure that we increase that? As we go forward in the business The others return on equity now shareholders are going to be very keen on this because equity if you recall that's their money If we go to the balance sheet, we've got the assets at the top part of the balance sheet things that we all Own then we have liabilities. Those are the things that we owe And the difference between those is the money that belongs to the shareholders Shareholders equity if we were to liquidate the firm today And sell off all the assets and use that money to pay off all the debts The bottom money left is shareholders equity. It's what they now have in the business Now our current year shareholders equity is 12.8 percent Last year was a negative 17. So again substantial improvement year over year And again, what does this mean? It means that for every dollar of shareholders equity And it's resulting in return of about 12 cents Okay What was our goal? What was our target to be determined and we're going to talk more about is that enough of an analysis to do And you're getting going to get a guess right now that no, it's not Let's move on to to debt The discussion of debt and or leverage It's called leverage because we're leveraging other people's money to generate a return to operate the business We're going to be interested in two key ratios here One is the debt to equity ratio And we're going to look at debt to assets So remember debt is money that we borrowed And equity is money that belongs to the shareholders Assets are presumably those things that the firm invested in To support the business operation for growth and going forward Now let's look at the debt to equity. This is also known as the risk ratio. Why? The more debt you have The more risk is inherent in the business now. What is the risk? What we talk about risk here is it's the risk of default It's possible that you are so much in debt That the bank and or shareholders are sitting back and saying If they are unable to pay that debt back what happens? It's bankruptcy and there's a huge cost to Shareholders if there is a bankruptcy So we want to monitor and manage our debt to equity So here we're going to look at total liabilities divided by total equity In this case note that our total liabilities is 1.5 million Our total equity was 1.9 million. So the debt is less than equity And we have a debt to equity ratio at ratio 0.77 And last year it was 0.83 Now I'm going to make this a tad more complex. Let's think about what this means At 0.77 for every dollar of shareholders equity, we have about 77 cents in debt Now a debt ratio debt to equity ratio of 1.1. What does that mean? It means that there's a dollar in liability and a dollar in equity So both the shareholders and the debt holders are on an equal level. It's one for one Now that's not necessarily bad and here's the here's the challenge for for business, especially between the executive staff and the financial group How much debt should we hold? And that's a that's a question that is analyzed constantly and is a big part of building the capital plan for the business And we talked about the capital plan in unit one The capital plan says how much debt and how much equity do we use to do the business to conduct business Now debt is risky, but only if there's too much debt How much is too much? It depends We want to have enough debt So that we can we feel comfortable being able to we have a Good enough cash flow that we can monitor and and take care of that debt And remember debt is to the advantage of the shareholders As debt increases the return on equity to shareholders increases why? Because we're using somebody else's money not just theirs to generate a return And so they can have a positive impact But we can't have too much debt because it increases the risk the risk of the fall The other interesting thing about that is that the more debt we have typically the higher the cost of debt If you've ever been out looking for a loan Depending on your credit rating and the amount of money you're looking for You can wind up paying a higher interest rate for that debt So all of these are part and parcel of discussion. It goes into how much debt But we're going to manage and monitor that debt to equity very very carefully So having said that we also want to know what the relationship is between the debt that we have and the assets Remember that probably a good part of debt has been used to acquire assets that we're going to use for the in the operation So now we're going to look at our total liabilities and divide that by total assets We now have a debt to asset ratio of 0.43. That's the current year Last year was 0.64. It's gone down Now here what this 0.43 means is that for every one of those dollars of assets in the 3.5 million We have about 43 cents of liabilities now The higher the ratio The higher the potential for risk why because as that ratio goes up It means that the amount of debt and proportion to assets is increasing I think what happens at some point where the debt is greater than the assets That's a potential issue with liability So we again, what what is the right number a lot of it depends on the business What you're actually doing in the business right now is are you in a growth plan? Are you in a maintenance plan and what's going on in the industry? But we want to carefully evaluate and monitor the amount of debt we're using And the amount of assets that we're we're acquiring Now a couple more ratios that I that I think are very important For us to think about in our business because it it's it goes to What value are we creating one of the key responsibilities of the management team in any business is to create value That means how do I make the business? worth more Week over week quarter over quarter year over year my creating value for the owners and shareholders And two key measurements that we're going to look at is the price to earnings ratio and the market to book value Now before we get into ratios, let's just talk about these terms for a minute Price what price are we talking about here? We're talking about the price of a share of stock Now the stock does not have to be sold in the market I can be a sole proprietor have No outside shareholders, but I can I can establish not to be traded stock What is the price of a share of stock if I wanted to bring in another investor and they wanted to buy a thousand shares What would we charge? So the price of a share of stock and the earnings now we know what the earnings are bottom line of the income statement And so the earnings is what is the earnings per share of stock? Suppose the earnings of the the net income at the bottom of our income statement was $100 And we have 10 shares of stock What what are the earnings? It's $10 a share All right, so we're going to look at the price to earnings ratio What what is the market seeing as the price the value of that share of stock? And what is it actually producing in earnings? And there's some interesting things to consider here And the second ratio we want to look at is the market to book value The market value again is what does the market say a share of stock is worth? Remember the price of stock is determined by the market I don't get to set the price of stock for a share of stock in my company the market does The market is looking at performance. They're looking at competition They're looking at what we're doing and what the what the future Possibilities are for the firm and they're making all those and putting it into a value decision And saying we're going to value a share of stock at x number of dollars The book value is the actual value on the books novel idea. What is the book? It's the balance sheet What is the book value of a company? Take the assets convert it to cash Pay off all the liabilities and what's left is the book value of the company It's shareholders equity That's what the company is worth Now if the book value of the company is a hundred dollars and you have 10 shares of stock Then the book value per share is 10 dollars Now if we've got the the idea about what these mean, let's take a little bit of A venture here to doing some calculations on ratios The price to earnings ratio We're going to take the market price of a share of stock now If this is publicly traded and you you own any stock or you've looked at the market or The exchanges you see that market prices are going up and down all the time So we'll take an average market price per share And we'll divide that what the market says a share of a share is worth Let's divide it by the actual earnings per share Now in this case our stock is trading at 12 dollars and 17 cents a share Earnings was a dollar one per share So the price to earnings ratio is 12 times Or the market is willing to pay 12 times what the actual earnings per share are Now before I go any further Think about what that means If the actual earnings on a share of stock is a dollar Why would the market pay 12 dollars a share? If you think about that a minute, there's only one reason That's because the market is looking at where the firm has been What we're currently doing And they're looking at forecasts on where the company can go and they obviously feel Positive that we are going to do better over time Now last year our PED ratio was 9.7. It was less So i'm going to guess that in the last year We have done some things improve financial performance as we have you seen from the prior Ratios, and so the market is feeling a little bit better about our stack Now when you look at the PE ratio by the way is commonly used by investors And one of the neat things about the PE ratio is it doesn't matter about the industry It's it's just an easy way to look at How the market views a share of stock and what it's actually earning and it makes it easy for us to do some comparisons Among competitive companies and even what the industry is doing Now a high PE ratio Could indicate a growth stack That's why it's paying a premium 12 times 15 times as that goes up the market is saying We feel really comfortable that this company is about to Uh do substantially better. It's a growth stack A low PE ratio Indicates a value stack. What do I mean by value? It means that the market Price for the stack and the returns are pretty capable. We're not looking for any major growth in this It's maybe considered a safer investment if you have no expectation of making a large increase or a large return Okay, so you will see this ratio used very often when people are talking about a stack offering or when they're comparing Opportunities to invest in very stacks. Okay, so price earnings ratio And by the way, there is much more information in the course on exactly what these Indicators are and there's also a tremendous amount of information out there online on these They're very very common and very popular topics and financial management The next is the market to book ratio So we want to evaluate how the market is valuing our stock And what is that stock compared to what the book value is? So the market ratio is the market capitalization same. It's 12.17 12,017 cents a share The total book value member assets minus liabilities equal shareholders equity Lessons sales expenses the projected cash flow project margins My question now is is I are we doing against the plan? Readable is it correctable? Do we have to make a change or here's one? Suppose that by the when we start a plan at the beginning of the year Like we again in restate our forecast Maybe we have to bring the other parts of the forecast we had if you're going to forecast less sales We will leave less equipment less materials We're going to compare the numbers to historical performance And we're going to compare the numbers to What's taking place in our industry? All right three kinds of comparatively To make a good decision you have to spend the time upfront together all the necessary data that you're going to need Talk to all the people you have to talk to Conduct all the studies and the analysis And then sit down and use that information to make a decision on any part of the business And so as a as a former president ceo, I can tell you this carrier was Disney company which I'm sure service and customer response why because they were known as some of they have some of the Generating a number and then moving forward Generating the numbers is simply the starting point of what we're going to do Now in our next presentation where we do anything else Let me just go back on michael and see if there's any questions so far. Um, no questions right now. I'll tell