Question

What is the purpose of a financial ratio analysis? Identify and define a financial ratio for each of the following categories:

Liquidity Ratios

Leverage Ratios

Activity Ratios

Profitability Ratios

Growth Ratio

Which do you think is/are most important to a company in making financial forecasts? Why?

Answer 1

Purpose of financial ratio analysis :

It helps to study short term & long term solvency analysis of the company. It also helps to determine operating efficiency of the firm.

I) Liquidity ratio : It determines ability of organisation to pay it's liabilities in a timely manner Following are the ratios:

a) Cash ratio : Compares cash & short term investments to short term liabilities.

b) Current ratio : Compare current assets to current liabilities.

c) Quick ratio : Same as cash ratio but it includes accounts recievables as an assets.

II) Leverage ratio : Followings are the ratio

a) Debt equity ratio : It indicates ratio between the total liabilities & total equity.

b) Equity multiplier : It is the ratio of assets & equity

c) Degree of financial leverage : It measures the sensitivity of EPS (Earnings per share) to its sensitivity of operating income.

d) Interest coverage ratio : It indicates the ability to pay interest liabilities on it's debt.

III) Activity ratio : Followings are the ratio

a) Total assets turnover : It measures the firms ability to generate income using it's total assets.

b) Current assets turnover = It measures the ability to generate sales or revenue through current assets.

c) Inventory turnover : It indicates how many days company needs to turn it's inventory into sales.

d) Cash conversion cycle : It measures the working capital use efficiency.

IV) Profitability ratio : Followings are the ratio

a) Net profit margin : It measures the company's ability in terms of profit.

b) Operating income margin : It measures the operating income of company, generated by sales.

c) Return on assets : It indicates that how well company can utilize it's assets.

d) Return on equity : It measures the company's ability to generate profit from stockholders investments.