Question

Please provide a detailed response.

Investors, analysts, and managers utilize financial ratios to analyze a company. Explain and discuss financial ratios. As a manager would you care more about liquidity, solvency, or profitability ratios? Why?

Answer 1

RATIO ANALYSIS IS THE BEST WAY TO ANALYSE THE FINANCIAL STATEMENTS OF A COMPANY STATEMENTS,Often managers start from the assumption that a profitable business is also a successful one. Usually, this premise is hugely flawed. Why? Because profitability is just one of the possible perspectives from which the manager should focus to understand the performance of a business.

In fact, often you see profitable businesses, which inevitably fail because of a shortage of short-term resources, which can be defined as liquidity.

The part of the balance sheet that you look at to assess liquidity is the current asset section and compare it with the current liabilities

Of course, the most appropriate ratios to measure liquidity are the Quick Ratio or Acid Test or the Current Ratio. At other times you can use the Absolute Ratio, but it is a less reliable measure compared to the previous ones.

Liquidity ratios measure your company's ability to cover its expenses. The two most common liquidity ratios are the current ratioand the quick ratio. Both are based on balance sheet items.

The current ratio is a reflection of financial strength. It is the number of times a company's current assets exceed its current liabilities, which is an indication of the solvency of that business.

The Quick Ratio is also called the "acid test" ratio. That's because the quick ratio looks only at a company's most liquid assets and compares them to current liabilities. The quick ratio tests whether a business can meet its obligations even if adverse conditions occur..

There are many types of ratios that you can use to measure the efficiency of your company's operations. In this section we will look at four that are widely used. There may be others that are common to your industry, or that you will want to create for a specific purpose within your company.

The inventory turnover ratio measures the number of times inventory "turned over" or was converted into sales during a time period. It is also known as the cost-of-sales to inventory ratio. It is a good indication of purchasing and production efficiency.

The data used to calculate this ratio come from both the company's income statement and balance sheet.

The sales-to-receivables ratio measures the number of times accounts receivables turned over during the period. The higher the turnover of receivables, the shorter the time between making sales and collecting cash. The ratio is based on NET sales and NET receivables. (A reminder: net sales equals sales less any allowances for returns or discounts. Net receivables equals accounts receivable less any adjustments for bad debts.)

The return on assets ratio measures the relationship between profits your company generated and assets that were used to generate those profits. Return on assets is one of the most common ratios for business comparisons. It tells business owners whether they are earning a worthwhile return from the wealth tied up in their companies. In addition, a low ratio in comparison to other companies may indicate that your competitors have found ways to operate more efficiently. Publicly held companies commonly report return on assets to shareholders; it tells them how well the company is using its assets to produce income.

Solvency ratios measure the stability of a company and its ability to repay debt. These ratios are of particular interest to bank loan officers. They should be of interest to you, too, since solvency ratios give a strong indication of the financial health and viability of your business.

Working capital is a measure of cash flow, and not a real ratio. It represents the amount of capital invested in resources that are subject to relatively rapid turnover (such as cash, accounts receivable and inventories) less the amount provided by short-term creditors. Working capital should always be a positive number. Lenders use it to evaluate a company's ability to weather hard times. Loan agreements often specify that the borrower must maintain a specified level of working capital.