Question

Analysis of financial statements can be done in many ways. In Chapter 13 of your textbook it discusses horizontal and vertical analysis as well as ratio analysis. Pick three ratios that you think are the best indicator of a company's health. Explain what those ratios tell you about a company and why you chose them.

Answer 1

The three ratios that you think are the best indicator of a company's health:

Liquidity

Liquidity is a key factor in assessing a company's basic financial health. Liquidity is the amount of cash and easily-convertible-to-cash assets a company owns to manage its short-term debt obligations. Before a company can prosper in the long term, it must first be able to survive in the short term.

The two most common metrics used to measure liquidity are the current ratio and the quick ratio. Of these two, the quick ratio, also sometimes referred to as the acid test, is the more precise measure, since, in dividing current assets by current liabilities, it excludes inventory from assets and excludes the current part of long-term debt from liabilities. Thus, it provides a more realistically practical indication of a company's ability to manage short-term obligations with cash and assets on hand. A quick ratio lower than 1.0 is a danger signal, as it indicates current liabilities exceed current assets.

Solvency

Closely related to liquidity is the concept of solvency, a company's ability to meet its debt obligations on an ongoing basis, not just over the short term. Solvency ratios calculate a company's long-term debt in relation to its assets or equity.

The debt-to-equity (D/E) ratio is generally a solid indicator of a company's long-term sustainability, because it provides a measurement of debt against stockholders' equity, and is therefore also a measure of investor interest and confidence in a company. A lower D/E ratio means more of a company's operations are being financed by shareholders rather than by creditors. This is a plus for a company since shareholders do not charge interest on the financing they provide.

D/E ratios vary widely between industries, but regardless of the specific nature of a business, a downward trend over time in the D/E ratio is a good indicator a company is on increasingly solid financial ground.

Profitability

While liquidity, basic solvency, and operating efficiency are all important factors to consider in evaluating a company, the bottom line remains a company's bottom line: its net profitability. Companies can indeed survive for years without being profitable, operating on the goodwill of creditors and investors, but to survive in the long run, a company must eventually attain and maintain profitability.

The best metric for evaluating profitability is net margin, the ratio of profits to total revenues. It is crucial to consider the net margin ratio because a simple dollar figure of profit is inadequate to assess the company's financial health. A company might show a net profit figure of several hundred million dollars, but if that dollar figure represents a net margin of only 1% or less, then even the slightest increase in operating costs or marketplace competition could plunge the company into the red. A larger net margin, especially as compared to industry peers, means a greater margin of financial safety, and also indicates a company is in a better financial position to commit capital to growth and expansion.

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