- As we saw from the financial statements of Walmart,
you can get a lot of information,
just by doing a simple thing.
Divide one accounting number by another.
The results of these calculations
are called financial ratios.
Now of course, there are hundreds
of possible financial ratios, but here we will discuss
just six key financial ratios.
We will learn the debt ratio, the current ratio,
return on sales, asset turnover, return on equity
and price earnings ratio.
Now, debt ratio is computed as total liabilities
divided by total assets.
Debt ratio is a measure of a company's leverage.
Leverage is a common way to describe the degree
to which a company has borrowed the money,
needed to buy its assets, compared to getting that money
as investments from owners.
For Walmart, for example, as of January 31st 2018,
the $124 billion of total liabilities,
relative to its $204 billion in total assets,
means the company borrowed about 60% of all the money
it needed to buy its assets.
Now, where did Walmart get the other 40%?
That 40% was invested by shareholders.
Walmart's debt ratio of 60%, tells you the extent
to which Walmart has financed
its business through borrowing.
Now, by comparison, Target has borrowed 70%
of all the money it needs to buy its assets.
A rule of thumb for large companies around the world,
is that the debt ratio is usually between 50 and 60%.
So, we see that Target has a bit more leverage than average.
Now if leverage gets too high, lenders become nervous
about the borrower's ability to repay its loans.
Debt ratio, total liabilities divided by total assets,
is a measure of leverage.
Now a second widely use ratio, is the current ratio.
Current ratio is a measure of a company's liquidity,
which means the ability of the company
to pay its obligations in the short term.
Current Ratio is computed as current assets divided
by current liabilities.
Now, I think we should pause here
to learn what a current asset is
and what a current liability is.
A current asset is an asset
that you expect to use within the coming year.
Cash, for example, is a great current asset.
Specific dollars are not going to sit there for a year,
you're going to use them, circulate them and replace them.
Inventory is also a current asset.
Hopefully, you're going to sell and then replace
specific items of inventory within the coming year.
Current liabilities are obligations
that you expect to pay within the coming year.
For example, you expect to pay your suppliers
within 30 or 40 days.
So accounts payable is a current liability.
You expect to pay your employees soon,
so wages is a current liability.
The current ratio for Walmart here is 0.76,
$60 billion of current assets
divided by $79 billion of current liabilities.
Now, let's stop for a second, because that 0.76
should make you just a little nervous.
I'm going to explain to you in just a minute,
that we don't need to worry about Walmart.
But let's be nervous for just a moment,
because Walmart doesn't have enough current assets,
to be able to pay all of its current liabilities today.
Scary, but of course,
Walmart doesn't actually have to stop today,
and pay all of its current liabilities
with its existing current assets.
So how does Walmart pay its obligations
on an ongoing basis?
With the cash that flows every single day,
Walmart has a current ratio that is less than one,
but that is not a concern because of Walmart's stable
and reliable operating cash flows.
Now historically, banks like to see less stable companies
have current ratios of two or higher.
That means if you had to pay all of your current liabilities
today with your current assets,
You'd have a cushion of more than two to one.