The key question in ratio analysis isn't only to get the right answer but to start working on ratio analysis by asking:”What are we trying to find?”
By using ratio analysis, we will determined whether the business
1. is profitable
2. has enough money to pay its bills
3. could be paying its employees higher wages
4. is paying its share of tax
5. is using its assets efficiently
6. has a gearing problem
7. is a candidate for being bought by another company or investor
Once we decided what we want to know then we can decide which ratios we need to use to answer the question or solve the problems we are facing.
1.1 The Ratios
By making a list of the ratios, we can categories it into different categories: Liquidity ratios, Asset management ratios, Leverage ratios, Profitability ratios, Market value ratio- which simplifies our calculation and help us answer question regarding the firm’s financial position. The categories we want to use, section by section, are:
1) Profitability: has the business made a good profit compared to its turnover?
a) Gross profit margin
b) Net profit margin
c) Return on asset
d) Return on equity
2) Liquidity: does the business have enough money to pay its bills?
a) Current ratio
b) Quick ratio
3) Asset management: how has the business used its fixed and current assets?
4) Leverage: does the company have a lot of debt or is it financed mainly by shares?
a) Debt ratio
b) Debt equity ratio
c) Time interest earned
5) Market value: are the firm’s managers creating shareholder value?
a) Earnings per share (EPS)
1.2 Purposes of Financial Ratio
After figuring out the kinds of questions we need to ask and know the ratios available, we need to know who might needed those information. This is an important issue because the person asking for that information will normally need to know something particular. That person seeking this information can come from internal or external of the firm.
Internally, this... [continues]
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