# Ratio Analysis

Pages: 11 (2373 words) Published: January 16, 2013
Ratio Analysis

Ratio Analysis is a form of Financial Statement Analysis that is used to obtain a quick indication of a firm's financial performance in several key areas. The ratios are categorized as Short-term Solvency Ratios, Debt Management Ratios, Asset Management Ratios, Profitability Ratios, and Market Value Ratios. Ratio Analysis as a tool possesses several important features. The data, which are provided by financial statements, are readily available. The computation of ratios facilitates the comparison of firms which differ in size. Ratios can be used to compare a firm's financial performance with industry averages. In addition, ratios can be used in a form of trend analysis to identify areas where performance has improved or deteriorated over time. Because Ratio Analysis is based upon accounting information, its effectiveness is limited by the distortions which arise in financial statements due to such things as Historical Cost Accounting and inflation. Therefore, Ratio Analysis should only be used as a first step in financial analysis, to obtain a quick indication of a firm's performance and to identify areas which need to be investigated further. The pages below present the most widely used ratios in each of the categories given above. Please keep in mind that there is not universal agreement as to how many of these ratios should be calculated. You may find that different books use slightly different formulas for the computation of many ratios. Therefore, if you are comparing a ratio that you calculated with a published ratio or an industry average, make sure that you use the same formula as used in the calculation of the published ratio. Short-term Solvency or Liquidity Ratios

Short-term Solvency Ratios attempt to measure the ability of a firm to meet its short-term financial obligations. In other words, these ratios seek to determine the ability of a firm to avoid financial distress in the short-run. The two most important Short-term Solvency Ratios are the Current Ratio and the Quick Ratio. (Note: the Quick Ratio is also known as the Acid-Test Ratio.) Current Ratio

The Current Ratio is calculated by dividing Current Assets by Current Liabilities. Current Assets are the assets that the firm expects to convert into cash in the coming year and Current Liabilities represent the liabilities which have to be paid in cash in the coming year. The appropriate value for this ratio depends on the characteristics of the firm's industry and the composition of its Current Assets. However, at a minimum, the Current Ratio should be greater than one.

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Example Problems |
Use the information below to calculate the Current Ratio.| Current Assets: \$| |
Current Liabilities: \$| |
Current Ratio:| |
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Quick Ratio
The Quick Ratio recognizes that, for many firms, Inventories can be rather illiquid. If these Inventories had to be sold off in a hurry to meet an obligation the firm might have difficulty in finding a buyer and the inventory items would likely have to be sold at a substantial discount from their fair market value. This ratio attempts to measure the ability of the firm to meet its obligations relying solely on its more liquid Current Asset accounts such as Cash and Accounts Receivable. This ratio is calculated by dividing Current Assets less Inventories by Current Liabilities.

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Example Problems |
Use the information below to calculate the Quick Ratio.|
Current Assets: \$| |
Inventory: \$| |
Current Liabilities: \$| |
Quick Ratio:| |
|
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Debt Management Ratios

Debt Management Ratios attempt to measure the firm's use of Financial Leverage and ability to avoid financial distress in the long run. These ratios are also known as Long-Term Solvency Ratios. Debt is called Financial Leverage because the use of debt can improve returns to stockholders in good years and increase their losses in bad years. Debt...