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: liquidity, solvency, and profitability.

1. Liquidity Ratio

Liquidity means the ability of the business to pay its short-term liabilities. The inability to pay-off short-term liabilities affects its credibility as well as its credit rating. Continuos 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 Defence Ratio

(e) Net Working Capital Ratio

2. Solvency Ratio

The Long-term Solvency Ratio 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 about:

(a) Periodic payment of interest during the period of the loan and

(b) Repayment of principal amount on maturity.

3. Profitability Ratio

The Profitability Ratio measures the profitability or the operational efficiency of the 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.

Ratios affected by Inventory are:

(a) Inventory Turnover Ratio

(b) Current Asset Ratio

(c) Net Working Capital Ratio

(d) Debt to Assets Ratio

(e) Asset Turnover Ratio

Different Ways to Improve the financial ratio

To Improve liquidity ratio:

(a) Early invoice submission

(b) Switch the short-term debt to long-term debt

(c) Writeoff useless assets

To Improve solvency ratio

(a) Increase in Sales

(b) Increase Owner's Equity

(c) Increase profitability

To improve profitability ratio

(a) Reduce inventory

(b) Close unprofitable products and services

(c) Reduce overheads