I'm glad that you decided to take the plunge. In our first short lesson, we're going to look at financial analysis. financial analysis is used for all sorts of purposes. managers, financial and non financial alike use financial analysis to interpret financial information. That is, what is the information telling us is if something good is if something bad Are we on target behind target or ahead of target, what is working and what isn't? investors use financial analysis to identify and evaluate investment opportunities.

Accountants use financial analysis to identify areas of potential errors or to describe variances from plans and bankers use financial analysis to evaluate the financial health of their borrowers. financial analysis involves studying trends, making comparisons and calculating different Types of ratios. trends are important for getting an understanding of the future direction of cash flow, are sales increasing or decreasing? And how about expenses? What is the growth rate of the industry, comparisons can be made between periods between companies in the same industry or totally unrelated companies. These comparisons can identify areas of either under or over performance.

Ratio analysis is particularly helpful for supplementing trend or comparative analysis. A ratio takes two or more financial accounts and relate them to one another. Consider these common examples of financial ratios. Gross profit margin, which is the amount of profit you generate on the sale of each unit of inventory, divided by sales, and expressed as a percentage operating margin, which is the amount of profit you generate after paying all of your overhead Buy your sales and expressed as a percentage return on equity, which is the net income divided by the balance of shareholders equity expressed as a percentage current ratio, which is a measure of solvency, that is the ability to pay bills as they come due. It's calculated by taking your current assets, assets that can be easily converted to cash and dividing it by your current liabilities, which are any obligations that are payable within one year.

And finally, your debt to equity ratio, which is a measure of financial leverage. That is the degree of debt used by the company to finance its operations. We're going to come back to this in a later lesson. I've developed a course covering all of the different types of financial analysis and ratios that are used in practice. So for more information or a deeper understand Standing, I suggest you go there or refer to the teaching supplement that I'm providing with this course that summarizes all of the various ratios and their purposes. To become proficient at financial analysis, you need to appreciate the difference in perspective between accountants and financial analysts.

The main reason is because much of this ratio analysis and trend analysis that we just talked about is based on an accountants view of the world. Now accounts keep the records and report the results. The financial analyst on the other hand, analyzes and interprets them. Recognize that both perspectives are useful and valuable. It's like looking at the same coin only from opposite directions. Left sensitize you by working through an example.

Let's substitute a balance sheet of Microsoft Corporation for the coin for a moment, a balance sheet shows the value of assets, liabilities and equity of a business at a specific point in time, often December 31. At midnight, it adds up all the various categories of assets does the same for liabilities. And the difference represents the residual interest I talked about during the introduction. Let's look at the shareholders equity section of the balance sheet. Specifically, the shareholders equity is made up of a number of line in what accountants call accounts. capital stock or common stock typically represent the value of the money received when the shares were issued initially, which by the way is in all likelihood different than the amount you paid for your shares.

Retained earnings represents the amount of net income generated by the business but not yet distributed in the form of dividends. Accounts calculate the amount of net income a company makes, which is quite simply revenue minus expenses. positive net income flows into retained earnings and dividends paid to shareholders gets posted against this account. When you take the value of shareholders equity and divided by the number of shares a company has issued and outstanding, you are calculating the book value of equity per share. This is an accountants view of value, but it's rarely the true market value because it's based on historical performance. The finance view of the world is different finance people are forward looking.

The market of buyers and sellers set the return expectation for this company, and this is signaled by the trading price. The stock price is significantly influenced by the expectation of future earnings. The stock markets tend to favor earnings and not cash flow as cash flow tends to be a little more erratic between years. Note the variation from finance theory, which dictates that cash flow not earnings to determine value. Practical insight number one duly noted, notice that we can take that 8.1 billion shares and multiply it by the $47 and 47 cent trading price to calculate what is called market capitalization of 380 $4 billion. When compared to the accounts view of shareholders equity that we saw on the previous slide, this number is 4.19 times higher.

This gap in value is a result of the very profitable business model of Microsoft that relies on intellectual capital and so called internally generated goodwill instead of hard capital like real estate and a question meant that would typically show up on a balance sheet to generate the returns. But it still annoys me that investors largely ignore cash flows. Fortunately, the financial statements contain a statement that helps us better understand cash flow better. In this course, we will spend a lot of time talking about the difference between accounting income and cash income, but just realize that in practice the to vary. Accounting income is full of non cash charges, such as depreciation, amortization, accruals of various sorts, and dozens of other adjustments that exist to report transactions in the most appropriate period. cash income, on the other hand, is a little harder to gain because it is what it is.

Both perspectives are important, but they're almost never the same over any given period. However, over the lifecycle of a company, cash income and accounting income will balance it To exactly the same thing, sometimes it takes a long, long time to see the convergence. In this lesson we talked about financial analysis. financial analysis is a core skill that requires strong financial literacy. The accountants financial statements form the backbone of financial analysis. However, it doesn't tell a complete story and must be supplemented with other sources of information.

For instance, stock market information or operational information. As we talked about during this lesson, financial analysis is used to assess financial state and to forecast the future which is the topic of our next lesson.