Question

Respond to the following in a minimum of 175 words:

• Describe the 3 main categories of ratios and provide a specific example of a ratio that is used in each category. For each of the 3 ratios you selected, describe how it is used in managerial decision-making.

Answer 1

Three main categories of ratios :

(A) Liquidity Ratio : Liquidity ratio speaks about the short term liquidity of the company. By computing  liquidity ratio, determination of debtors ability to pay off current debts can be assessed. It includes current ratio , quick ratio etc.

Management uses liquidity ratio to know the short term financial power and debts pay off capacity of the company .

(B) Solvency ratio : Solvency ratio speaks about the long term ability to pay off debts including interest and principal. Apart from that it also says about the ratio of composition of funds in the capital structure. Debt equity ratio, debt ratio, proprietary ratio are the common solvency ratio used in companies .

Management uses solvency ratio , to know the external financing needs and  long term abundance of financial benefits. Management can easily assume the capacity of paying long term debts by having solvency ratio .

(C) Profitability ratio : It speaks about the earnings capacity or the overall profitability of the company. It includes gross profit margin ratio, net profit margin ratio, operating profit ratio , ROI etc. Management uses this ratio for earning desired level of profit as well as maintaining balance growth for the organization.