Question

Financial Ratios fall into five general categories liquidity, activity, debt, profit-ability and market ratios.

1. Define each ratio:

2. As an investor describe how each ratio can be used to gain insight on a company's performance and its future.

Answer 1

Liquidity Ratios:

Liquidity ratios are the ratios that indicate the ability of a company to meet its short term debt obligations. These ratios measure the ability of a business to pay off its short-term liabilities when they fall due.

Generally, the greater the liquidity ratios are, the greater the margin of safety that the company have to meet its current obligations. Liquidity ratios greater than 1 indicate that the company is in good financial positions and it is less likely to fall into financial problems.

Activity Ratios:

An activity ratio is a type of financial tool that indicates how efficiently a company is leveraging the assets on its balance sheet, to generate revenues and cash.

Activity ratios are most useful to compare two competing businesses within the same industry and to determine how a particular company stacks up amongst its peers. Activity ratios may also be used to trace a company's fiscal progress over a period of time, to detect changes over time. These numbers can be mapped to present a forward-looking picture of a company's future potential performance.

Debt Ratios:

The debt ratio for a given company shows whether or not it has loans and, if it has, how its credits are financed compared to its assets. It is measured by dividing total liabilities by total assets, with higher debt ratios indicating higher degrees of debt financing.

A greater debt ratio (0.6 or greater) shows negative impact on the capability to borrow money. On the other hand, investors rarely purchase the stock of a company with extremely low debt ratios.

Profitability Ratios:

Profitability ratio is used to measure the company’s ability to generate income as compared to its expenses and other cost involved with the generation of income during a particular period. This ratio represents the final result of the company.

Profitability indicates final performance of company i.e. how profitable company is. It also represents how profitable owner’s funds have been utilized in the company.

Market Ratios:

The market ratios are the financial tool which are used to evaluate the stocks of publicly traded companies. These ratios are mainly used by investors to check whether the share’s prices are valued correctly in the market or they are trading at a higher price or lower price.

The market ratios are important for investors, management, etc as these ratios are used to decide whether the valuation of the shares are overvalued, undervalued or at par with the market. These ratios are used for making investment decisions in stocks of companies.