Question

Introduction to Ratios

The ratios we discuss and the ways that we calculate them are typical of the way companies or analysts may use ratios to analyze a business but they are not necessarily “the correct way” and other ratios and methods are not necessarily incorrect. The key things that you want to do when you use ratios are to try to use amounts that can give an insight into the business (such as EBIT per square foot, as we will hear mentioned by Geoff Ruddell from Morgan Stanley as a meaningful ratio in the retail industry) and to be consistent in the way that the ratios are calculated when comparing them between periods for a company or when comparing them for different companies.

In this course, when calculating ratios that include both balance sheet and income statement amounts, we generally use an average of beginning and ending balances for the balance sheet amount. Again, this is not the only way and it is not “more correct” than other ways; we do it because it relates the revenue or expense or income for the period with an average value of the balance sheet amounts for the period. It could be just as acceptable to use a four point average (quarterly balances) or a twelve point average (monthly balances) or just the ending balance (just the value with no average). You (or your company) can choose to do it in any of these ways; the decision should be based on the information you have available and the purpose of the ratio.

Also in this course, when calculating ratios that include two balance sheet amounts, we will generally use the balances at the end of the period. We are normally interested in these ratio relationships at a point in time so using some average balances tends to dull the point. However, different analysts or companies may be looking for different insights from the ratios and they may find it useful to use average balances for these ratios. Again, ratios can be used in different ways to show different things.

Max 200 words: Think about a company you are familiar with. If you were a manager at that company, what kind of ratios would you want to see? How do you think these ratios would help you in your decision-making?

Answer 1

I assume that I am manager at MC donalds. As a manager i would be most interested in finding efficiency ratios because it helps in judging my contribution to the business and the emphasis would be be placed on three main items of the balance sheet:

• Accounts receivable: sums of money to be received by customers.
• Inventories: materials held into the business to be ultimately sold or transformed into a final product.
• Accounts payable: sums of money to be given to suppliers for the purchase of raw materials or other services

From these three things Accounts receivable turnover ratio,inventory turnover ratio and acounts payable turnover ratio can be calculated . Accounts receivable turnover ratio will help me as a manager important decisions regarding how much credit sales to be made so that there is no shortage of liquid money because it ensures smooth flow of operations. Next inventory turnover ratio will give idea about how fast inventory is getting sold which indicates that the items kept are high in demand among customers and not outdated . If turnover for any product is low the production of that product will be lowered or stopped. Similarly Accounts payable turnover will help us to decide for how long we an use the moeny of suppliers to carry out operations and when they need to be paid back. If the turnover is low it will block furtehr supplies which will hamper the production process