Question

3. Ratio analysis is an extremely important tool utilized by financial statement analysts in determining the future value of a corporation’s stock. Discuss which ratios you believe are the most useful in determining the future viability of a company. Include in your discussion the importance of benchmarks and red flags that are obvious indicators of future problems. Include specific discussions we had in class to enhance your argument. Give specific examples.

Answer 1

Discuss which ratios you believe are the most useful in determining the future viability of a company

Ratios I believe most important are:

• The current ratio measures your company's ability to generate cash to meet your short-term financial commitments. Also called the working capital ratio, it is calculated by dividing your current assets—such as cash, inventory and receivables—by your current liabilities, such as line of credit balance, payables and current portion of long-term debts
• Inventory turnover looks at how long it takes for inventory to be sold and replaced during the year. It is calculated by dividing total purchases by average inventory in a given period. For most inventory-reliant companies, this can be a make-or-break factor for success. After all, the longer the inventory sits on your shelves, the more it costs.
• Net profit margin measures how much a company earns (usually after taxes) relative to its sales. A company with a higher profit margin than its competitor is usually more efficient, flexible and able to take on new opportunities.
• Return on equity (ROE) measures how well the business is doing in relation to the investment made by its shareholders. It tells the shareholders how much the company is earning for each of their invested dollars. It is calculated by dividing a company’s earnings after taxes (EAT) by the total shareholders’ equity, and multiplying the result by 100%.

Include in your discussion the importance of benchmarks and red flags that are obvious indicators of future problems.

Running a business is alike human body. When we are about to get sick we feel unenergitic, feel iritated and want rest. Simialry in a business also, when it is about to get sick it may show prior symptoms like poor financial ratios, cash crunch etc. It is important to understand that ratios are compared in relation with industry averages as well as prior periods performance in line with the budgeted figures. Also, keep the figures in mind which shall keep the alarm to analyse what is wrong and what needs to be corrected. In bank loan arrangements, bankers give covenant conditions to maintain the certain capital outlay as well ratios at a determined level or else loan arrangement will be revoked for this purpose only so they can safeguard themselves.

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