Financial Ratios

Topics: Generally Accepted Accounting Principles, Financial ratios, Balance sheet Pages: 18 (4389 words) Published: February 6, 2011


Current Ratio: = current assets / current liabilities

▪ The higher the ratio, the greater the "cushion" between current obligations and a firm's ability to meet them. ▪ Use: An indication of a company's ability to meet short-term debt obligations; the higher the ratio, the more liquid the company is. Current ratio is equal to current assets divided by current liabilities. If the current assets of a company are more than twice the current liabilities, then that company is generally considered to have good short-term financial strength. If current liabilities exceed current assets, then the company may have problems meeting its short-term obligations. For example, if XYZ Company's total current assets are $10,000,000, and its total current liabilities are $8,000,000, then its current ratio would be $10,000,000 divided by $8,000,000, which is equal to 1.25. XYZ Company would be in relatively good short-term financial standing. ▪ Good: If total assets are greater than liabilities

▪ Bad: If total liabilities are greater than assets
▪ Who uses it and or what purpose? Analysts use current ratio in financial statement analysis. ▪ How it can be manipulated and what causes it to vary? Changes in trend o the Current Ratio can be misleading. If the current ratio exceeds 1:1 an increase in equal amount in both current assets and current liabilities ( by acquiring inventory into an account) results in a decline in ratio, whereas equal decreases ( by paying an accounts payable) Results in increased current ratio. ▪ How can Management leverage this knowledge? Management can manipulate current ratio by taking deliberate steps to produce a financial statement that presents a better current ratio at the balance sheet data than the average or normal current ratio during the rest of the year. For Example: near the end of an accounting period a firm might delay normal purchases on an account or might collect receivables for loans to officers, classified as non current assets and use proceeds to reduce current liabilities. When the current ratio exceeds 1, the usual situation, such actions will increase current ratio. ( window dressing) ▪ However, Requires Careful Analysis of the Quality of Receivables and Inventory.

Quick Ratio: = Current Assets- Inventories / Current Liabilities

▪ The acid test ratio (Quick ratio) is computed by current assets minus inventory divided by current liabilities. Thus this relates the most liquid assets to current liabilities. ▪ This is the most stringent test of liquidity.

▪ The usual guideline for the ratio is one to one.
▪ Short-term creditors will use this as an indication of a firm's ability to satisfy its short- term debt immediately. ▪ The management of the firm will have a greater difficulty borrowing short-term funds if the firm has a low quick ratio. If the ratio is very low, it is an indication that the firm will not be able to meet its short-term obligations. ▪ When using liquidity ratios the analyst will start with receivables and inventory, if a liquidity problem is suggested further analysis using the current and quick ratio will be used and the analyst will form an opinion accordingly. ▪ Its use and what constitutes a “good” or “bad” indication/comparison: Use: Indication of a firms ability to satisfy short- term debt immediately. Good:

Bad: If there is a low quick ratio management will have a hard time borrowing short term funds. If very low the firm will not be likely to meet its short term obligations.

▪ Who uses it and for what purpose? Analysts: viewed as a sign of company's financial strength or weakness (higher number means stronger, lower number means weaker).

▪ How it can be manipulated or what causes it to vary?

▪ By including inventory with current assets. So there is nothing to subtract...
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