Question

Discuss financial ratios for the purpose of financial analysis:

•mention uses and limitations

•choose three ratios from different categories (such as liquidity, asset management, debt management, profitability, etc.)

Answer 1

LIQUIDITY RATIOS

These ratios are used to measure the company’s ability to repay the short term and long term obligations

-Current Ratio

It is the ratio of current assets to current liabilities of a company

Current ratio = Current assets / Current liabilities

Uses: It is used to know the ability of a company to repay its short term liabilities.

It is always better to have this value greater than 1, because if it is grether than ! then only it will be able to pay its short term liabilities

Limitations: Using only this ratio does not help to analyze exact liquidity position of the company as it relies on the amount of current assets instead of the quality of the asset.

-Quick ratio

Quick ratio or Acid test ratio is the ratio of quick assets to current liabilities of a company

Quick ratio = Quick assets / Current liabilities = Current assets – Inventories / Current liabilities

Uses: It is used to know the ability of a company to repay its short term liabilities using quick assets. It can be used to compare companies in same industry.

Limitations: the quick ratio does not provide exact information of assets and liabilities and is not useful in cases where we need to compare companies from various industries.

-Cash ratio

Cash ratio is ratio of cash and cash equivalents to of quick assets to current liabilities of a company

Cash ratio = Cash and Cash equivalents / Current Liabilities

Uses: It is used in fundamental analysis of a company

Limitations: It does not provide the exact analysis of a company, because it is not realistic to maintain excess Cash and Cash equivalents in order to repay the liabilities.

ASSET MANAGEMNT RATIOS

These are also called Efficiency ratios, and these ratios help to measure efficiency of a company by measuring how the company is utilizing its assets / resources.

-Asset Turnover ratio

It is the ratio of net sales to the total assets available in the company.

Asset turnover ratio = Net sales / Total assets

Uses: It is used to measure the ability of a company generate sales from assets available.

Limitations: It is a measure of sales rather than measure of profits. So, this ratio doesnot determine how well the company is earning profits.

-Inventory Turnover ratio

It is the ratio of cost of goods sold to the average inventory of the company

Inventory turnover ratio = Cost of goods sold / Average inventory

where

Average inventory = (Inventory at the beginning of a period + Inventory at the end of a period)/2

Uses: It is used to measure how many times the inventory is sold and replaced in a given period. Thus it determines the efficiency of a company in handling its goods.

Limitations: It provides the average number of times per year that the inventory is sold and replaced instead of giving the exact value.

-Accounts Receivable Turnover ratio

It is the ratio of net credit sales to the average accounts receivable over a period

Accounts Receivables turnover ratio = Net credit sales / Average accounts receivable

where

Average accounts receivable= (accounts receivable at the beginning of a period + accounts receivable at the end of a period)/2

Uses: It is used to measure how many times the company can turn its receivables into cash over a given period. Thus it determines the efficiency of a company in handling its goods.

Limitations: one limitation is that some companies use total sales instead of net sales, which inflates the results thereby misleading the investors.