In: Finance
Discuss how peer group ratio comparison works. Discuss the purpose of each ratio and how each ratio is related to liquidity risk.
Peer group ratio comparison involves looking into peer companies operating in the same line of business and in same industry and comparing their ratios to get an understanding of the industry dynamics. Every industry has a typical range of values for different ratios. A bank and an airline cannot be compared on the basis of ratios.
Peer group ratio comparison is extensively used by investment banks and managers involved in trading. Even every company wants to see where it stands relative to the competitors.
There are many ratios which are used. It depends on our purpose that we decide on which ratios to look for.
Liquidity is the ability to quickly convert assets to cash without loss of value
Liquidity risk information can be got from current ratio which is current assets/current liabilities.
We can also look into quick ratio which is (current assets - inventory - prepaid expenses)/ current liabilities
There is also cash ratio = cash & cash equivalents/current liabilities
The purpose of current ratio is to give a picture of assets which can be used within a year to pay current liabilities. It shows the ability of the company to pay its short term liabilities. If it is less than one then typically the company is in trouble.
Quick ratio is similar but we exclude inventory as it takes time to liquidate. Inventory is not as liquid as other current assets. This ratio measures the real short term liquidity.
Cash ratio gives a picture of how much cash is available to pay off short term debt with cash and equivalents.
Analysts typically have peer group ratios and compare each individual company to the peer average to get an understanding of how good the company is relative to the peers