Question

What is the purpose of a financial ratio analysis? Identify and define a financial ratio for each of the following categories:

Liquidity Ratios

Leverage Ratios

Activity Ratios

Profitability Ratios

Growth Ratios

Which do you think is/are most important to a company in making financial forecasts?
Using research, obtain information on the financial ratios from McDonald's identified above for the organization.

Answer 1

Financial ratios are used by investors and management to assess firm performance and operational effectiveness. Management uses financial ratios to determine how well their firm is performing in order to evaluate where the firm can improve. By comparing financial ratios between companies and between industries, investors can better determine the best investment.

Liquidity Ratios: Liquidity ratios deal with a firm's short-term financing and debt. By being liquid, a firm is quickly able to convert assets to cash, and pay off interest. The main liquidity ratios are the current ratio and quick ratio.

where CR is current ratio, CA is current assets, and CL is current liabilities.

Leverage Ratios: Leverage ratios involve the amount of debt used to finance a firm's assets. A firm can finance through debt or equity. The firm must eventually pay back debt, while equity is an investment in the company. The main leverage ratios are debt to equity ratio and long-term debt to capitalization ratio.

The debt to equity ratio measures the relative proportions of debt and equity funds used to finance the firm’s assets and is defined as: where D is debt and E is total equity.

Activity/Operational Ratios: Operational ratios show a firm's performance. For example, accounts receivable turnover ratio shows the firm's performance in collecting accounts receivable. Inventory turnover ratio shows a firm's performance in converting inventory into cost of goods sold.

Profitability Ratios: Profitability ratios provide information about management's performance in using the resources to run the business. It shows the return on sales and the profitability of the firm. The main profitability ratios are Gross profitability, Net profitability, return on assets, return on equity and return on capital employed.

Return-on-assets measures the amount of profit generated by each dollar of assets and is defined as: , where PAT-Profit after Tax and A is the total average asset.

Growth Ratios: Growth ratios can give an indication of how fast your business is growing. They can also be used to benchmark company performance over time and in different economic environments. Examples are Net Income growth, Sales growth, Operating Income Growth, Cash Flow growth.

Growth Ratios, Profitability Ratios, Activity Ratios, Leverage Ratios are most important in this order.

Source: http://financials.morningstar.com/ratios/r.html?t=MCD

Current ratio: 1.84

Debt to Equity ratio: N/A

Inventory turnover ratio: 207.30

Return-on-assets: 16.02%

Net Income YoY Growth: 10.79%