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Level I CFA: FRA Financial Analysis Techniques-Lecture 2 - YouTube
Channel: IFT
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coming now to what i believe is the most
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important section in this reading common
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ratios
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used in financial analysis
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what we'll do first is identify the
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different categories
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we can have activity ratios which
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essentially
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measure how efficiently a company is
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performing
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a classic example of a activity ratio
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is revenue divided by assets
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this is also called the asset turnover
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ratio this is
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showing that per unit of assets how much
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revenue
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is a company generating there are
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several other
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activity ratios which we will see on the
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next slide
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liquidity ratios we have seen before in
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the reading
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on the balance sheet solvency ratios
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were also discussed
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in the balance sheet reading
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profitability ratios
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we saw briefly in the income statement
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reading
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they tell us about the profitability of
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a company
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examples would include net income over
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sales
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and here we will also look at mixed
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ratios
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where the numerator comes from the
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income statement and the denominator
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comes from the
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balance sheet valuation ratios we will
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touch
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briefly in this reading but we will see
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in
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a lot more detail later when we study
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equity and fixed income
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essentially here we are looking at the
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quantity of an
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asset or a flow on a per share basis
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a classic example would be eps
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or we might also have ratios such as
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price
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to earnings ratios in earlier readings
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we generally focused on single statement
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ratios
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so we had ratios from the income
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statement such as the gross profit
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margin
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operating margin or net profit margin
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then from the balance sheet we had
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liquidity ratios and solvency ratios
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and with the cash flow statement we had
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ratios that took
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a numerator and a denominator from the
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cash flow statement
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now we will spend a lot of time on mixed
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ratios
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where the numerator comes from the
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income statement and the denominator
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from the
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balance sheet the numerator could also
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come from the
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cash flow statement as a general
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point you need to be careful about how
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you
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interpret ratios the interpretation
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should be in the context of the goals
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and strategy of the company that you are
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evaluating
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industry norms and economic conditions
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let me elaborate consider two companies
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intel and amd they are in the same
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business
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both make chips but they follow
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different strategies
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intel is a market leader it tries to
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come up with new and
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innovative products whereas amd
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is a follower amd essentially tries to
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copy what intel is doing that is putting
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it very
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simplistically clearly even though the
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two companies are in the same
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industry but they follow different
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strategies
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so chances are that their ratios will be
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different clearly the r
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d expenditure for intel will be much
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more than the r
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d expenditure for amd which might imply
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that
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overall the asset assuming that rnd is
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eventually capitalized
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the assets for intel might might be
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higher
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relatively speaking without getting into
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the details
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the point is that these different
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strategies impact
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ratios so when we compare the two
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companies we need to be aware that the
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goals and strategies are slightly
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different
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industry norms is a very important point
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clearly a ratio
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is good or bad depending on how that
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ratio is relative to the standard in the
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industry the current ratio in a given
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industry might be
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one on average whereas in another
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industry the current ratio might be 0.3
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so when you are coming up with the ratio
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for a company it
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needs to be looked at in the context of
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the
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industry economic conditions means that
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the ratio you come up with should be
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considered
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with respect to the current state of the
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economy
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if the economy is in a recession then in
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general
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net income and operating income will be
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low so
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profitability ratios are likely to be
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low on the other hand
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if the economy is booming then the
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profitability ratios are likely to be
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high let's take a deeper look at
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activity ratios here are the activity
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ratios that you essentially
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need to learn and over the next few
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slides i will take you over these
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ratios and help you understand what they
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mean
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help you interpret them and help you
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remember them let's start with the first
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one which is extremely important
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the inventory turnover ratio the formula
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is cost of goods sold divided by average
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inventory and the interpretation of this
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ratio is that it tells us
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how many times per period was
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the entire inventory sold
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this is a theoretical number it's an
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approximation
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but just to let you understand where
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this is coming from
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think of it this way let's say that over
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a period
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the cogs for a company was 200
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and during the same period on average
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the inventory was equal to
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10. the inventory turnover ratio then is
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200 over 10 which
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is 20. so what is the interpretation of
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20
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this is approximately the number of
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times per
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period so this period that the entire
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inventory was sold
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now a few more remarks about this ratio
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notice that the income statement item is
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in the numerator
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and the balance sheet item is in the
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denominator
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we also use average inventory the point
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is that
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if at the end of the year it just turns
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out that the
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inventory number is very high because
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the company is building up for the next
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year
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but in general during the year the
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inventory was maintained at 10
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then clearly it makes sense to use 10 as
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your denominator and not
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25. as a financial analyst however you
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might not know the exact
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average inventory so what you would
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normally do
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is use the average of the beginning
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period inventory which you can get
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through the financial statements and the
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ending period inventory the principle
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though is that you should ideally
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use the average if you don't have those
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numbers you just have the end of period
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number then
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that's what you use hoping that the end
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of period number is
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indicative of the average inventory
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during the year
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if you have access to quarterly reports
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and you have
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inventory numbers for the end of every
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quarter that
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is very good because then you can get a
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more accurate
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average inventory number by using all
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the
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end of quarter numbers this should be
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obvious but i will state it anyway
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a higher number for the inventory
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turnover ratio
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shows greater efficiency if you have
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another
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company that manages to have a lower
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inventory balance with the same cost of
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goods sold
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that means it is managing its inventory
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better
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and it might have a higher turnover
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ratio such as
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25. you also need to understand this
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item
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days of inventory on hand this is
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calculated by taking the number of days
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in a period so if we are taking
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a one year period then we have 365 days
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in a period
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divided by the inventory turnover
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ratio in our simple example if we have
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365
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divided by 20 then the days of inventory
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on hand
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is 18.25
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this is a measure of on average how many
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days of
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inventory do we maintain obviously if
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the activity ratio is
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higher then that means that on average
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we maintain
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a lower amount of inventory
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receivables turnover ratio
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this is the revenue divided by
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average receivables and this measures
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how quickly
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a company collects cash
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generally it would be more appropriate
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to use credit sales
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divided by average receivables rather
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than
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revenue but often credit sales
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numbers are not available therefore
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analysts
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tend to use the revenue number
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a higher number for this ratio shows
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greater efficiency we also
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need to calculate the days of sales
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outstanding
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this again is the number of days in a
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period if we are considering a year
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then we have 365 days divided by the
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receivables turnover ratio
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if this number is large that means that
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it takes us
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a long time to collect our receivables
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payables turnover ratio this is
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purchases divided by average trade
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payables and the interpretation is the
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number of times per year
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that a company pays its supplier
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as an analyst you might not have access
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to the
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purchases account then what you use
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is the cost of goods sold plus change in
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inventory if you have a given period
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where
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cogs is equal to 200
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the inventory at the start of the year
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was
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10 and at the end of the year is
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30 then this means that the purchases
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must have been 200 plus the change which
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is 20
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so purchases must have been 220
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so that is the precise measure to use
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at times an analyst might simply use
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purchases as approximately equal to
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cogs in terms of interpreting the
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numbers
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a relatively high number for the
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payables turnover ratio would mean that
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a company is not making good use
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of credit facilities a very low ratio
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might indicate possible liquidity
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problems
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the working capital turnover ratio is
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revenue divided by average
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working capital this tells us how
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efficiently
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a company generates revenue from its
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working capital
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and just to remind you working capital
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is equal to your current assets minus
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current liabilities at times if the
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current assets and current liabilities
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are roughly the same
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then this number would be approximately
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zero and
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the ratio would be meaningless
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we can also look at the fixed assets
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turnover ratio and the total assets
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turnover ratio the total asset turnover
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ratio is revenue divided by average
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total assets and this tells us how
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efficiently a company generates
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revenue from total assets
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we have looked at several ratios
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and you might be wondering how you can
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remember them
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i'll give you a very simple technique
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that will make it
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easy for you the first point is that the
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name
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tells you the balance sheet item notice
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that in all these
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ratios you have a income statement item
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in the numerator
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and the balance sheet item in the
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denominator
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with the receivables turnover ratio we
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have average receivables over here
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with the total asset turnover ratio we
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have total assets
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over here so clearly you know the
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balance sheet
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item based on the name from the balance
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sheet item you can determine
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the relevant income statement item if we
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have
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assets in the denominator the relevant
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item
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in the numerator is revenue if we have
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inventory as your balance sheet item
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then the relevant item
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would be cost of goods sold so
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based on the balance sheet item you can
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figure out the relevant
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income statement item as i've already
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mentioned
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the income statement item is going to be
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in the numerator
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for our activity ratios and then also
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notice that
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in general with the balance sheet item
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we use a
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average value if you can remember these
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four points then that will allow you to
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remember
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all the activity ratios
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you
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