Question

Explain the significance of following-

1. Profitability ratio

2. Liquidity ratios

3. Leverage ratios.

Explain in detail.

Answer 1

Explain the significance of following

1

Profitability Ratio

Profitability ratios are ratios used to assess whether the company is able to generate profits or not

These ratio tells the users whether the company is able to make profits from the revenue generated and how much percent profit the company is able to make from the revenues generated. This is done by calculating the gross profit ratio and net profit ratio

Calculating ratios like return on assets, the investors are able to analyse the efficiency of use of assets to produce the revenue for the company

Calculating return on equity helps the shareholders the return the company is able to generate to shareholders based on investment opportunities undertaken by the company from the shareholders fund

With these ratios, it will help to analyse the cash flow generating ability of the company

2

Liquidity Ratios

Liquidity ratios are ratios calculated to analyse the ability of the company to pay the short term obligations

Liquidity ratios like current ratio compares the current assets and current liabilities, this helps to understand whether the company has sufficient short term assets to pay off the short term liabilities of the company. Current assets less than the current liabilities is an indication that the company is lacking funds and may not be able to make payment of short term obligations

Secondly liquidity ratios like acid ratio are use which helps to analyse the quick or instead assets which can be easily converted into cash and whether these assets are sufficient to pay the short term obligations. Inventories are excluded from current assets to calculate this ratio

In Short, these ratios helps to keep a check on the liquidity position of the company

3

Leverage Ratios

Leverage ratios are ratios use to check the debt level of the company by comparing with various accounts in balance sheet, income statement or cash flow statement

This ratios helps to keep a check at the debt level of the company and to avoid excessive debt which may lead to non payment

Comparison of debt with income statement helps to anaylse whether the company is able to generate enough profits so that it is able to make annual interest and principal payments

Comparison of debt with equity helps the investors to understand whether the company is relying too much on outside liability for its requirement

It is important for the company to have debt level which the company is able to pay. Excessive debt may hinder the growth for the company on the long term