Question

How can I, do I or should I, perform a financial analysis using financial ratios to evaluate the firm's liquidity, solvency, and profitability for two sequential years using Amazon as the company?

Answer 1

1. Liquidity

Liquidity refers to an enterprises ability to convert its assets to cash and pay off its short term obligations without any significant difficulty.

Liquidity ratio's - The higher the ratio, the better the company's liquidity position

Liquidity ratio's - Financial ratios to evaluate firms liquidity:

a. Current ratio: It measures the ability of the company to repay the current liabilities with current assets.

Current ratio = Current assets ÷ Current liabilities

Current assets = Stock, Debtor, Cash & bank, receivables, loan & advances, and other current assets

Current liabilities = Creditor, Short-term loan, bank overdraft, outstanding expenses, and other current liability

Analysis - A Current ratio of 1 or more means that the current assets are more than the current liabilities and the company should not face any financial difficulty. Generally 2:1 is treated as the ideal ratio, but it depends on industry to industry.

b. Quick ratio or Acid test ratio: This ratio is more conservative than the current ratio. Instead of all current assets only those assets which can be readily converted into cash are considered. Generally 1:1 is treated as an ideal ratio.

Quick ratio = Quick assets ÷ Current liabilities

Quick assets = Cash and Cash equivalents+ Marketable Securities + Receivables

Current liabilites = Current liabilities = Creditor, Short-term loan, bank overdraft, outstanding expenses, and other current liability.

2. Solvency

Solvency refers to an enterprised ability to pay off its obligations or debts as they become due.

Solvency ratio's - Financial ratios to evaluate firms Solvency:

a. Debt ratio: (also known as debt to assets ratio) measures debt level of a business as a percentage of its total assets. In a sense, the debt ratio shows a company’s ability to pay off its liabilities with its assets. this ratio quantifies the percentage of a company's assets that have been financed with debt (short-term and long-term).

Debt ratio = Total Debt ÷ Total assets

b. Debt to Equity ratio: The debt to equity ratio is a financial, liquidity ratio that compares a company’s total debt to total equity. it measures the degree to which the assets of the business are financed by the debts and the shareholders' equity of a business.

Debt to Equity ratio = Total Debt ÷ Total equity

Other ratio's - Times interest earned ratio, Fixed charge coverage ratio etc.

3. Profitabiltiy

Profitability ratios measures the ability of the business to earn profits for its owners.

Profitability ratio's - Financial ratios to evaluate firms Profitability:

a. Profit margin ratio: measures the amount of net income earned with each dollar of sales generated by comparing the net income and net sales of a company

Profit margin ratio = Net Income ÷ Net sales

b. Return on assets: measures the net income produced by total assets during a period by comparing net income to the average total assets,

Return on assets = Net Income ÷ Average Total assets

c. Return on equity: measures the ability of a firm to generate profits from its shareholders investments in the company.

Return on equity = Net income ÷ Shareholders equity

Other ratio's - Return on capital employed, Earning per share, Dividend payout ratio, Price to earning ratio etc.