AI Finance Use Cases - Part 2: Ratios
AI Finance Use Cases - Part 2: Ratios
Non-finance managers and executives often struggle with financial analysis. It is very rare that these managers get a formal education in finance. Such components are typically part of an Executive MBA program. However, even executive MBAs provide very high-level financial advice and sometimes overlook simple and straightforward concepts.
In this series of articles, we will use generative AI to do financial analysis for us. We will go from very simple concepts to more advanced ones. This series will explore the depth and breadth of financial analysis using generative AI. In the first article we cover the vertical analysis techniques. In this article, we will cover financial ratios.
Financial ratios are very important, as they provide a measure of the health of a company. Ratios allow for comparisons between companies of different sizes since they are expressed as percentages or relative figures.
Disclaimer: we are not financial experts. This series aims to empower non-financial managers with AI tools, not to replace financial professionals.
We first set up our AI with a specific persona.
System Prompt
We start with a system prompt to define the desired AI personality. We have defined the role as:
You are a CFO with 20 years experience in financial analytics.
Ratios
If you don’t know what are ratios in the financial analysis world, you can ask your favorite LLM to explain to you first.
Prompt 5: Definition
What are ratios?
Answer
Ratios are financial tools used to evaluate the performance, financial condition, and profitability of a company. They are derived from a company’s financial statements - namely the balance sheet, income statement, and cash flow statement - and provide insights into various aspects of the business. Ratios are typically used by management, investors, creditors, and analysts to make decisions regarding investments, lending, and management strategies.
There are several types of financial ratios, including:
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Liquidity Ratios: These measure the ability of a company to meet its short-term obligations. Common liquidity ratios include the Current Ratio and the Quick Ratio.
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Solvency Ratios: These assess a company’s ability to meet its long-term obligations and its financial leverage. Examples include the Debt to Equity Ratio and the Interest Coverage Ratio.
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Profitability Ratios: These evaluate how well a company uses its resources to generate profit. Important profitability ratios include the Gross Profit Margin, Operating Margin, and Return on Assets (ROA).
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Efficiency Ratios: These ratios examine how effectively a company uses its assets and liabilities internally. Key efficiency ratios include Inventory Turnover, Receivables Turnover, and Asset Turnover.
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Market Value Ratios: These provide insight into the stock market’s valuation of the company and include the Price to Earnings Ratio (P/E), Price to Book Ratio (P/B), and Dividend Yield.
Each ratio provides a different perspective on the financial health and operational efficiency of a company, and when used together, they offer a comprehensive view of the company’s overall performance.
Prompt 6: Reducing Complexity
The above list is a good list, but covers many aspect of a company that may not be relevant for all companies. If your company doesn’t have debt, solvency ratios are not relevant. If your company is not listed, there are no market value ratios. If you are a service company, the inventory turnover is not relevant.
Let’s ask our AI CFO to make selection of the 5 key ratios relevant to our case. We need to describe our companies key characteristics for the model to provide relevant information. The name of the company, or the industry will not be enough to get good results.
List the 5 key ratios that I need to consider, knowing that our company has no debt, is not listed, is a service company with no inventory, outsources very little, has no tangible assets, outsources a very small percentage of the work but relie mainly on internal resources to deliver.
Answer
Given the specific characteristics of your company, the following five key financial ratios would be particularly relevant to assess its performance and financial health:
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Current Ratio: This ratio measures the company’s ability to pay off its short-term liabilities with its short-term assets. It is calculated by dividing current assets by current liabilities. This is important for a service company to ensure liquidity, even without inventory considerations.
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Net Profit Margin: This ratio indicates how much of each dollar earned by the company is translated into profits. It is calculated by dividing net income by total revenue. This is crucial for a service-based company to monitor, as it reflects the efficiency in converting revenue into actual profit.
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Return on Assets (ROA): Since your company relies heavily on internal resources rather than tangible assets, this ratio will help measure how efficiently those resources are being used to generate profit. ROA is calculated by dividing net income by total assets. Even with minimal tangible assets, this ratio can provide insights into the overall effectiveness of resource utilization.
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Operating Cash Flow Ratio: This ratio provides an indication of the company’s ability to generate cash from its operating activities, an essential aspect for any company, especially one without significant tangible assets or inventory. It is calculated by dividing operating cash flow by total debts. This ratio helps ensure that the company can sustain its operations through the cash it generates.
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Gross Profit Margin: This ratio is crucial for a service company as it measures the financial health of its core activities. It shows the proportion of money left over from revenues after accounting for the cost of goods sold (COGS). In a service company, COGS would primarily include direct labor costs and direct project expenses. It is calculated by subtracting COGS from revenue and then dividing that number by revenue.
These ratios provide a comprehensive view of liquidity, profitability, efficiency, and cash flow, which are critical for a service-based company like yours that relies heavily on internal resources and has minimal tangible assets or inventory.
Prompt 7: Documents Needed
We now need to provide to our AI powered CFO the financial documents that contains the information needed for the financial ratios. Let’s ask what document is needed.
What financial documents are mandatory to compute these ratios?
Answer
To compute the financial ratios mentioned, you will primarily need the following financial documents:
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Balance Sheet: This statement provides a snapshot of a company’s assets, liabilities, and shareholders’ equity at a specific point in time. It is essential for calculating liquidity ratios like the Current Ratio and solvency ratios. It also provides the total assets needed for the Return on Assets (ROA) calculation.
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Income Statement (Profit and Loss Statement): This document outlines the company’s revenues, expenses, and profits over a specific period. It is crucial for calculating profitability ratios such as Net Profit Margin and Gross Profit Margin. The net income figure from this statement is also used in the ROA calculation.
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Cash Flow Statement: This statement shows the inflows and outflows of cash due to operating, investing, and financing activities. It is necessary for calculating the Operating Cash Flow Ratio, as it provides the total cash generated from operating activities.
These documents together provide a comprehensive view of the company’s financial health and are indispensable for conducting a thorough financial analysis through ratios. Each document contributes different pieces of information that are crucial for assessing various aspects of the company’s financial performance and stability.
Made Up Numbers
To test the ability of generative AI to compute ratios, we will first generate fake data. We also could use real financial information. Using generated financial can also help us simulate different types of issues and their financial impact.
We’ll use another conversation, so it does not pollute our analysis conversation with our AI CFO.
Prompt Fake Data
Generate a consistent and realistic set of financial documents for a service company, using mainly its internal employees to deliver services, with no tangible assets. The three documents we need are a balance sheet, an income statemant, and a cashflow statement.
Answer
Certainly! Below is a simplified example of a set of financial documents for a hypothetical service-based company, “ServicePro Inc.”, which primarily uses its internal employees to deliver services and has no tangible assets. This example assumes the company has been operational for a few years and has stable revenue streams.
Company: ServicePro Inc.
Fiscal Year: 2023
| Balance Sheet (as of December 31, 2023) | |
|---|---|
| Assets | Amount (USD) |
| Current Assets | |
| Cash and Cash Equivalents | 50,000 |
| Accounts Receivable | 120,000 |
| Prepaid Expenses | 30,000 |
| Total Current Assets | 200,000 |
| Total Assets | 200,000 |
| Liabilities and Equity | |
| Current Liabilities | |
| Accounts Payable | 40,000 |
| Accrued Expenses | 60,000 |
| Unearned Revenue | 20,000 |
| Total Current Liabilities 120,000 | |
| Equity | |
| Common Stock | 50,000 |
| Retained Earnings | 30,000 |
| Total Equity | 80,000 |
| Total Liabilities and Equity | 200,000 |
| Income Statement (for the Year Ended December 31, 2023) | |
|---|---|
| Revenue | Amount (USD) |
| Service Revenue | 500,000 |
| Expenses | |
| Salaries and Wages | 300,000 |
| Rent | 50,000 |
| Utilities | 10,000 |
| Marketing | 20,000 |
| Insurance | 15,000 |
| Other Operating Expenses | 30,000 |
| Total Expenses | 425,000 |
| Net Income | 75,000 |
| Cash Flow Statement (for the Year Ended December 31, 2023) | |
|---|---|
| Cash Flows From Operating Activities Amount (USD) | |
| Net Income 75,000 | |
| Adjustments to reconcile net income | |
| Increase in Accounts Receivable | (20,000) |
| Increase in Prepaid Expenses | (10,000) |
| Increase in Accounts Payable | 10,000 |
| Increase in Accrued Expenses | 20,000 |
| Increase in Unearned Revenue | 5,000 |
| Net Cash Provided by Operating Activities | 80,000 |
| Cash Flows from Investing Activities | |
| Net Cash Used in Investing Activities | 0 |
| Cash Flows from Financing Activities | |
| Issuance of Common Stock | 0 |
| Net Cash Provided by Financing Activities | 0 |
| Net Increase in Cash and Cash Equivalents | 80,000 |
| Cash at Beginning of Period | (30,000) |
| Cash at End of Period | 50,000 |
Notes: ServicePro Inc. is a service-based company with no tangible assets, focusing on delivering services through its internal employees.
The company maintains a lean operation with minimal fixed assets and focuses on liquidity and operational efficiency.
The financial statements are prepared in accordance with generally accepted accounting principles (GAAP).
This example provides a basic overview of the financial health and operations of a service-based company. Adjustments and more detailed entries might be necessary depending on the specific industry, regulatory requirements, and other factors specific to the company.
Computing our Ratios
Prompt 8: Compute
We just need to compute our real (or fake in this case) numbers into a simple prompt.
Compute the 5 key ratios based on below numbers: (...)
Answer
Based on the financial data provided for ServicePro Inc. for the fiscal year 2023, we can compute the following key financial ratios:
Current Ratio = Total Current Assets / Total Current Liabilities = 200,000 / 120,000 = 1.67 This ratio indicates that for every dollar of current liabilities, the company has $1.67 in current assets, suggesting good short-term financial health.
Net Profit Margin = Net Income / Revenue * 100 = 75,000 / 500,000 * 100 = 15% This shows that 15% of the revenue is converted into net profit.
Return on Assets = Net Income / Total Assets * 100 = 75,000 / 200,000 * 100 = 37.5% This high percentage indicates efficient use of assets to generate profit.
Operating Cash Flow Ratio = Net Cash Provided by Operating Activities / Total Current Liabilities = 80,000 / 120,000 = 0.67 This ratio suggests that the company generates $0.67 in cash from operations for every dollar of current liabilities.
Gross Profit Margin:
First, we need to calculate the Gross Profit. Since there are no direct costs of goods sold (COGS) mentioned and it’s a service company, we assume major direct costs are part of operating expenses. However, typically, Gross Profit for a service company would be considered as Revenue minus direct service-related expenses (mainly salaries here).
Assuming salaries are the direct cost:
Gross Profit = Revenue - Salaries and Wages = 500,000 - 300,000 = 200,000
Gross Profit Margin = Gross Profit / Revenue * 100 = 200,000 / 500,000 * 100 = 40% This indicates that 40% of the revenue remains after subtracting the direct costs associated with providing the service.
These ratios provide a comprehensive view of ServicePro Inc.’s financial health, indicating good profitability, asset utilization, and reasonable cash flow management, although there might be room for improvement in cash flow generation relative to current liabilities.
Made Up Numbers
Made up numbers generated by LLM usually show good financial performance. If you want to experiment with different issues, you need to specify in the number generation prompt what type of issues the company is experiencing (cashflow issue, low profitability, high current liability, etc.). This will help you to understand the impact of this type of issues in the financial documents, and then in the financial ratios.
Ideal for Non-Finance Managers
These few prompts won’t be useful for experience CFO, but can provide great value for non-financial managers. It will:
- Increase there understanding of financial ratios,
- Leverage generation of fake data to illustrate financial issues,
- Avoid being lost in the financial jargon, especially multiple names for the same concept,
- Give the ability to further explore analysis perspective,
Stay tuned for Part 3 of our series where we delve into profitability analysis. Register to our newsletter to ensure you don’t miss it!
Technology
The above answers were generated by gpt4-turbo, running on azure infrastructure, using our internal web application.
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