Question

Why is each ratio listed below, important for financial decision making within the business? Please use own words and be descriptive.

Current Ratio

Quick Ratio

Debt Equity Ratio

Inventory Turnover Ratio

Receivables Turnover Ratio

Total Assets Turnover Ratio

Profit Margin (Net Margin) Ratio

Return on Assets Ratio

Answer 1

Current Ratio:

Current ratio is calculated by dividing current assets by current liabilities. Current ratio shows the liquidity of a company. Liquidity is the ability a company to meet it's short term obligations. Higher the ratio, higher is the liquidity of the business. A current ratio of 1 implies that book value of assets are exactly equal to the book value liabilities. Lower current ratio means a greater relaince on operating cash flow and the need to use external financing.

Quick Ratio:

Quick ratio is also a measure of liquidity. Quick ratio uses more liquid assets and therefore is more conservative than current ratio. Higher quick ratio indicates a higher liquidity.

Quick ratio = (cash and equivalents + marketable securities + accounts receivable) / current liabilities

Quick ratio reflects the fact that all inventory cannot be sold quickly and therefore, not included in the ratio. Quick ratio also reflects that fact that current assets such as prepaid expenses, some taxes represent costs of current period that have been paid in advance an cannot usually be converted into cash. Quick ratio can be a better indicator of liquidity than current ratio.

Debt Equity ratio:

Debt equity ratio is a solvency ratio that measues the amount of debt in relation to equity. Solvency measures a company's ability to meet long term obligations. A debt equity ratio of 1 indicate that equal amount of debt and equity is present in a company's balance sheet. A debt equity ratio shows how much a company's asset is financed by debt. A high debt equity shows that a company is aggressively financing it's growth using debt. A high debt equity ratio implies a higher risk.

Inventory turover ratio:

Inventory turnover ratio is an efficiency ratio calculated by dividing cost of goods sold by average inventory. Ineventory turnover shows how quickly a company is able to convert inventory into sales. A higher inventory turnover implies a shorter period that inventory is held. Inventory turnover ratio should be compared with the industry average. A higher turnover ratio compared to industry shows an efective management. Alternatively, a higher turnover can also mean that the company does not carry adequate inventory and thus missing out on sales. Slower growth combined with higher inventury can indicate inadequate inventory levels.

Receivables turnover ratio:

Receivables turnover ratio is also an efficiency ratio which shows how quickly a company is able to collect money for the sales from it's customers. Receivables turnover ratio is calculated by dividing net credit sales / average accounts receivables. A higher receivables turnover might indicate a higher efficiency in credit collection practice of the company. Alternatively, a higher turnover could also state that companies credit collection policies are very strict which may result is losing sales to competitors. A low turnover might state that comapny has poor credit collection policies.

Total Assets Turnover Ratio:

Total assets turnover ratio is also an efficiency ratio which shows the company's overall ability to generate sales with a given level of assets. It is calculated by dividing revenue by total assets. A turnover of 1.5 states that for every $1 of assets, company is able to generate $1.5 in revenue. A higher turnover indicates higher efficiency. A lower turnover ratio can indiacte ineffciency. The ratio helps the management to decide on startegic decisions, i.e, whether to be labour intensive or capital intensive in production process.

Profit Margin (Net Margin) Ratio:

Net profit margin is a profitability ratio which is calculated by dividing net profit by total revenue. It shows how much profit is generated by each dollar of sales. Net profit is closely followed by shareholders as they seek how much revenue is converted to profit after deducting all the expenses. Ne income include both recurring and non recurring components. Net profit margin is normally calculated after adjusting for non recurring items to get a better overview.

Return on Assets Ratio:

Return on assets is also a profitability ratio calculated by dividing net income / average total assets. It shows how much returned is earned by the assets of the company. The higher the ratio, more income is generated by it's assets.