Question

Financial statement analysis focuses primarily on isolating information that is useful for making a particular decision. Through ratio analysis, users of financial data can analyze various relationships between items reported.  Describe the 3 main categories of ratios and provide a specific example of a ratio that is used in each category. For each of the 3 ratios you selected, describe how it is used in managerial decision-making.

Answer 1

1a) Ratio analysis is a widely used technique of analysing financial statements.An analysis of financial statements with the help of ratios ie termed as ratio analysis.it is a systematic use of accounting ratios to interpret the financial statements for studying the financial position and performance of an enterprise.ratios analyze also enable managerial decision making.

1.Liqudity ratios

The term liquidity refers to the firm's ability to pay its current liabilities out of its current assets.Liquidity ratios are used to measure the liquidity position or short term financial position of a firm. These ratios are used to assess the short term debt paying ability of a firm. These ratios are highly useful to creditors and commercial banks that provide short term credit. Important liquidity ratios are current ratio, quick ratio, super quick ratio etc.

Current ratio

current ratio is one of the oldest of all financial ratios. It was first used in 1891. Even today, it is the most common ratio for analysing liquidity or short term financial position. Current ratio is defined as the ratio of current assets to curren liabilities. It shows the relationship between total current assets and total current liabilities. Current ratio is also called working capital ratio or banker s ratio. It is calculated as follows: Current Ratio Current Assets

Current Ratio = Current assets /Current Liabilities

In short, current ratio is a measure of the ability of a firm to pay its current liabilities out of current assets.

Liquid Ratio or Quick Ratio

Liquid ratio is the ratio of liquid assets (or quick assets) to current liabilities. It establishes the relationship between quick assets and current liabilities. It is the measure of the instant debt paying ability of the business enterprise. It is also called acid test ratio. It is called so because the ratio is caculated to eliminate all possible illiquid elements from current assets. It is also called near money ratio. It is computed as follows:

Liquid ratio=Liquid Assets/ Current Liabilities

2.LEVERAGE RATIOS (or SOLVENCY RATIOS)

The term solvency refers to the ability of a firm to pay its outside liabilities (i.e, both long term and short term). Solvency may be short term solvency or long term solvency. Short term solvency refers to the ability of a firm to meet short term obligation in time.This is known as liquidity. The term long term solvency generally refers to the capacity or ability of a firm to repay the long term liabilities along with the interest due on them regularly. Long term liabilities include debentures, lono term loans etc. Thus long term solvency means long term liquidity. The term solvency generally means long term solvency.

Solvency (long term solvency) or leverage ratios are used to analyse the long term financial position of a business. In other words, these ratios are used to analyse the capital structure of a firm.

There are two types of solvency or leverage ratios. They are structural ratios and coverage ratios. Stuctural ratios are based on the relationship between owned.capitaland borrowed capital. These ratios are calculated from the balance sheet items. These are calculated to know the ability of the firm to repay the principal amount when due. Coverage ratios are computed from the profit and loss account. These are calculated to ascertain the firm's capacity to pay interest and dividend regularly.

Debt Equity Ratio

Debt to equity ratio is the most commonly used ratio to test the solvency of a firm. This ratio indicates the relative proportion of debt and equity in financing the assets of a firm. In short, it expresses the relationship between debt (external equity) and equity (internal equity). So, this ratio is also known as External - Internal Equity Ratio. Debt Equity ratio is sometimes referred to as security ratio. There are two forms of debt equity ratio - long term debt equity ratio and total debt equity ratio.

Long Term Debt Equity Ratio: This expresses the relationship between long term debt and equity. It is computed as follows:

Long term debt Equity Long Term Debt Equity Ratio= Components of Long term Debt/Equity

Fixed Asset Ratio

A fundamental principle of sound financial policy is that all fixed assets must be financed out of long term funds. Short term funds (current liabilities) should not be used for purchasing fixed assets. They shall be used only for working capital requirement. If short term funds are used in the purchase of fixed assets, it will afeet the liquidity position, It happens so because fixed assets will nave to be sold for paying off the short term liabilities, It will adversely affect the business. Fixed assets can be sold in most of the cases at a Joss. Moreover, it is not practicable also. To know Whether this fundamental principle is followed or not. fixed asset ratio is calculated. It is the ratio of fixed assets to long term funds or capital emploved, It is computed as follows:

Fixed assets ratio=Fixed assets(after depreciation)/Long term funds

3.ACTIVITY RATIOS

Activity ratios show how effectively a firm uses its available resources or assets. These ratios indicate efficiency in asset management. These ratios are also known as efficieney ratios or performance ratios or assets utilisation ratios. These ratios indicate the cash elasticity of current assets. In other words, these ratios indicate the speed with which the resources are turned over or converted into cash. That is why these ratios are called turnover ratios. Higher turnover ratio means better use of resources. This further means higher profitability. It should be noted that turnover ratios are always expressed in number of times, i.e., rate of turning over. Important activity or turnover ratios are discussed as follows: