Question

"Financial Analyst Skills" Please respond to the following:

• Assess the key ratios for profitability, liquidity, and solvency used by financial analysts to evaluate the financial performance of a company. Next, indicate one (1) ratio from each of the three (3) categories (profitability, liquidity, and solvency) that you believe to be most indicative of future performance. Use actual ratios from a company of your choice to provide support for your rationale.

Answer 1

Let’s understand profitability, liquidity and solvency ratios,

1) Profitability ratios help to understand whether the company is generating profits or not.

Net profit margin, operating profit margin and Return on capital are the important ratios to looked to understand the profitability of the company.

A)Net profit margin- Net income/ Revenue

This ratio defines, how much net income company has generated for every revenue it generated.

B)Oprating profit Margin- EBIT/Revenue

This ratio defines how much earnings company has generated after deducting cost of goods, selling and general expense and depreciation.

C)ROI- EBIT/Total Capital

This ratio defines how much earnings company has generated on the total investment made by the company.

From above ratios, ROI/ROC is the important ratio to look for as it not only help to understand the profitability but also how efficiently capital has been used.

Let’s take Apple Inc example to understand it better.

ROI for Apple is 25.71%, which states, it has generated $25 and 71 cents for every $100 invested in the company and continue to do so in future and this profit excess over investment will be reinvested to generate more profits.

2) Liquidity ratios are used to check the ability of the company to pay its short term obligations.

Current ratio, Quick ratio and Cash ratio are the important ratios one should understand.

A) Current ratio- Current Asset/Current Liability

It helps and investor to understand the how much current asset company is holding to pay its current liabilities.

B) Quick ratio- liquid current asset/ current liability

This ratio help to understand how much liquid assets company is having for its current liabilities.

Liquid assets are nothing but the cash, short term investments and receivables.

C) Cash ratio- (Cash + short term investment)/ current liabilities

This ratio defines how much cash available with company to pay its current liabilities.

From above ratios Current ratio is the important ratio to look for as it not only tells the liquidity of the company but also how efficiently company is managing its working capital.

In our example, Apple Inc has current ratio of 1.47 which states that company has liquid asset well above its current liabilities. Ratio more than 1 indicates healthy ratio which states working capital is managed efficiently.

3) Solvency ratios helps to understand firm financial leverage position.

A) Debt to Equity ratio- Debt / Equity

This ratio indicates how much proportion of debt and equity has been used as compared to Equity.

B) Debt /Capital ratio- Debt/(Debt + Equity)

It indicates how much proportion of debt has been used with total capital.

C) Interest coverage ratio- EBIT/ Interest Payment.

It indicates the ability of the company to its debt and interest liability.

From above ratio D/E ratio is the most commonly used to understand how leverage the firm is.

In case of Apple Inc, it is 1.57 which indicates firm is highly leverage and may have difficulties in future to raise more debt.