Question

Which of the financial ratios of a company would you refer to in each of the following situations? Give reasons.

(i) The company asks you to sell material on credit.

(ii) You are thinking of investing $25,000 in the company’s Bonds.

(iii) You are thinking of investing $25,000 in the company’s shares

Answer 1

Ans: Ratio analysis is basically a quantitative analysis toil being performed on the financial numbers of the business so that a comparative analysis across the industries can be performed. It is very powerful and widely used tool. I will use the following ratios for following situations:

1) The company asks you to sell material on credit: Now when I have to sell material on credit then definitely I would be willing to know the current ratio & Quick ratio of buyer, this current ratio will tell me whether the buyer has enough liquidity or not to pay off its short term obligation. If I find buyers current ratio as poor, I would not advise my company to see material on credit to such customer/ buyer.

2) You are thinking of investing $25,000 in the company’s Bonds: For investing money in Bonds, I would rather be interested in knowing the solvency ratio of the company, particularly Debt to total assets ratio, under this ratio, one can see that whether company is able to pay the liability by its assets or not, or if company has proper balance of debt and assets. Company with higher debt and lower assets are not the company to be invested in bonds, since there will be trouble in paying back your bond amount. I will also be interested in interest coverage ratio as well since this ratio will tell me whether company is capable in honoring its debt payments or not. A debt ridden company should be avoided for making any kind of investment specifically bond investment.

3) You are thinking of investing $25,000 in the company’s shares: I would rather be interested in knowing debt to equity ratio and return on equity ratio, debt to equity ratio will tell me the % of total capital in debt and in equity. Higher debt % company is to be further analyzed through debt to assets and interest coverage ratio. Return on equity ratio will tell me how profitable or how efficiently the company is using its capital in generating the profit. Higher RoE gives the bright prospect of investment.