The Role of Financial Ratios

Topics: Financial ratios, Generally Accepted Accounting Principles, Financial ratio Pages: 17 (4980 words) Published: March 16, 2011
The Role of Financial Ratios

Table of content

Chapter 1. Notion and types of ratios.4
1.1 Liquidity ratios.5
1.2 Financial leverage ratios7
1.3 Funds management ratios9
1.4 Profitability ratios12
Chapter 2. Use of financial ratios.15
2.1Use and Limitations of Financial Ratios15
2.2 Used financial data15
2.3 Financial ratios calculated for The Apple Company16
2.4 The Dupont Model18
Appendix 121

I have chosen this topic for my coursework because I find ratio analysis the most common way to evaluate the performance of an enterprise and its interest for investor. As in future I plan to work in a financial department, this analysis was of great interest for me. Financial analysis helps to answer many important questions like what was the performance of the enterprise, is it profitable to give loan to a client, will the share price increase in the nearest future and so on. And financial ratios are the most efficient and the easiest source of information for such analysis. From dozens of various financial ratios I have chosen the most widespread and common, analysed them in accordance with their meaning and use. I presented equations for calculations of financial ratios and worked out the procedure using the example of Apple Company. I have also found information about recommended value for some of these ratios. The results of my work are presented in this paper.

Chapter 1. Notion and types of ratios.
A financial ratio (or accounting ratio) is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Security analysts use financial ratios to compare the strengths and weaknesses in various companies.Financial ratios are useful indicators of a firm's performance and financial situation. Most ratios can be calculated from information provided by the financial statements. Financial ratios can be used to analyze trends and to compare the firm's financials to those of other firms. In some cases, ratio analysis can predict future bankruptcy. Financial ratios are divided into four groups:

* Liquidity ratios
* Firms leverage ratios
* Funds management ratios
* Profitability ratios.
These categories indicate that different ratios may be more helpful than others for particular purposes. Therefore, rather than calculating ratios indiscriminately, the experienced analyst begins by considering the kinds of insights that will be helpful in understanding the problem faced. The analyst then calculates those ratios that best serve his or her purpose. To get the most meaningful results, the analyst compares these ratios over a period of several years against some standard; examines in depth major variations from this standard; and cross-checks the various ratios against each other. 1.1 Liquidity ratios.

These ratios indicate the ease of turning assets into cash. They include the Current Ratio, Quick Ratio, and Working Capital. The Current Ratio is one of the best known measures of financial strength. It is figured as shown below: Total Current Assets

Current Ratio = ____________________
                        Total Current Liabilities The main question this ratio addresses is: "Does your business have enough current assets to meet the payment schedule of its current debts with a margin of safety for possible losses in current assets, such as inventory shrinkage or collectable accounts?" A generally acceptable current ratio is 2 to 1. But whether or not a specific ratio is satisfactory depends on the nature of the business and the characteristics of its current...

Bibliography: 1. Brigham, Eugene F. and Joel F. Houston. Fundamentals of Financial Management, Ninth Edition, Harcourt College Publishers, Fort Worth, 2001.
3. Susan M Mangiero WHY THE DUPONT MODEL IS IMPORTANT, Valuation Strategies, Proquest ABI/INFORM, 2004
5. Williams, Jan R.; Susan F. Haka, Mark S. Bettner, Joseph V. Carcello Financial & Managerial Accounting, McGraw-Hill Irwin, 2008.
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