Question

3. Explain how ratio analysis is used to analyze financial performance.

Answer 1

Ratio Analysis can predict a company's future performance.Successful companies generally boast solid ratios in all areas,where any sudden hint of weakness in one area may spark a significant stock sell-off.

Ratio analysis is a quantitative method of gaining insight into company's liquidity,operational efficiency and profitability by studying its financial statements.Investor and analyst employ ratio analysis to evaluate the financial health of comapnies by scrutinizing past and current financial statements.

Following are the example of Financial Ratios

i)Solvency Ratio:Example of solvency ratio include:debt-equity ratio,interest coverage ratio and debt-assets ratio.It measure the stability of a company and its ability to repay Debt.

ii)Liquidity Ratios:It measure a company's ability to pay off its short term debt as they become due using the comapny's current or quick assets.It include-cuurent ratio,quick ratio and working capital ratio.

iii)Profitability Ratio:These ratios convey how well a company can generate profits from its operations.Its example include-return on equity,return on capital employed and gross margin ratio.

iv)Efficiency Ratios:These ratio convey how efficiently a company uses its assets and liablities to generate sales and maximize profits.Efficiency Ratio include-Turnover ratio and inventory turnover.

v)Coverage Ratio:These ratio measure a company's ability to make the interest payments and other obligations associated with its debt.Coverage Ratio include-debt service coverage ratio and times interest earned ratio.

vi)Market Prospects ratio:These are most commonly used ratios in fundamental analysis.Market Prospects ratio include-dividend yield ratio,earning per share,and dividend payout ratio.