Question

There are three broad categories of financial ratios: liquidity, solvency, and profitability. Discuss what each category reveals about the company being analyzed. Give examples of ratios that are affected by inventory, and discuss changes a manager might make to improve the financial ratio.

Answer 1

There are three broad categories of financial ratios, that are ;1:liquidity ratio, 2:solvency ratio and 3: profitability ratio.

1)Liquidity ratio

The terms liquidity and short term solvency are used synonymously. Liquidity or short term solvency means ability of the business to pay its short term liability. Inability to pay off short term liabilities affects it credibility as well as its credit rating. Continuous default on the part of the business leads to commercial bankruptcy. Eventually such commercial bankruptcy may lead to its sickness and dissolution. Short term lenders and creditors of a business are very much interested to know its state of liquidity because of their financial stake. Both lack of sufficient liquidity and excess liquidity is bad for the organization.

Various liquidity ratios are:

a)current ratio  

b)quick ratio

c)cash ratio

d)basic defense interval ratio

E)net working capital ratio

2)Solvency or leverage ratio

The leverage ratios may be defined as those financial ratios which measure the long term stability and structure of the firm. These ratios indicate the mix of funds provided by owners and lenders and assure the lenders of the long term funds with regard to :

1)periodic payment of interest during the period of the loan and

2)repayment of principal amount on maturity

Examples :equity ratio, debt ratio, debt to equity ratio, debt to total asset ratio, capital gearing ratio, proprietary ratio etc

3)PROFITABILITY RATIO

The profitability ratios measure the profitability or the operational efficiency of firm. These ratios reflect the final results of business operations. They are some of the most closely watched and widely quoted ratios. Management attempts to maximize these ratios to maximize firm value.

The results of the firm can be evaluated in terms of its earnings with reference to a given level of assets or sales etc. These are classified into four, that are

# profitability ratio related to sales

# profitability ratio related to overall return on investment

# profitability ratio required for analysis from owner's point of view

# profitability ratio related to market /valuation /investors

Through having efficient account receivables, prompt submission of invoice, giving more importance to long term debt, controlling overhead expense a manager can improve their financial ratios

.. thank you