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In: Accounting

Ratio analysis compares the line-item data in a firm's financial statements, which will reveal many understandings...

Ratio analysis compares the line-item data in a firm's financial statements, which will reveal many understandings regarding liquidity, profitability, operational efficiency, and solvency. Moreover, ratio analysis can be used to look at trends for one or more firms within the same industry or sector. Ratio analysis compares line-item data.

Respond to the following in a minimum of 175 words:

  • List five major categories of ratios and explain how they could be used to help a firm.
  • What are the most important liquidity ratios and why?

Solutions

Expert Solution

RATIO ANALYSIS

        Ration analysis can be defined as a relationship between two figures that is expressed mathematically which are selected from the financial statement of an entity. This helps to draw conclusions about strengths, weaknesses and performance of the firm and also help in taking decisions in relation to the firm.

Categories of Ratios:
01.Liquidity Ratios
Liquidity ratio measures the firm’s ability to pay its short-term liabilities. Inability of firm to pay off its short-term obligations affects its credit rating. Lack of sufficient liquidity as well as excess liquidity is bad for the entity.
02.Solvency Ratios
Solvency ratio measures the long-term stability as well as structure of the firm. This ratio provide assurance to the lenders regarding the payment of interest due periodically as well as the repayment of the principal amount on maturity of the debt. This includes both capital structure ratios as well as coverage ratios.
03.Turnover Ratios
Turnover ratios evaluate the efficiency with which the firm utilizes its assets. These ratios are also called asset management ratios.
04.Profitability Ratios
This ratio measures the operational efficiency of the firm. Organizations tend to maximize these ratios to maximize the value of the firm. These ratios show the end results of the business operations.
05.Earning Ratios
This includes the profit earning ratio as well as the earnings per share. These ratios help potential investors as well as owners of the firm regarding the future prospect of the firm as well as the return expected from the firm in the future.

Important Liquidity Ratios
There are two important liquidity ratios:
01.Current Ratio
This ratio is the best-known measure of short-term solvency and is the most common measure of short-term liquidity. This is considered as an important liquidity ratio since this answer the question whether the firm has got enough current assets to meet its current liabilities on time.
02.Quick Ratio
Quick ratio is also called ‘acid-test’ ratio and is also considered as one of the best measures of liquidity. It is considered as an important liquidity ratio since it explains whether the firm will be able to meet its current obligations if ever the sales revenue had disappeared.

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ekkarill92 answered 2 years ago
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