ratios
boco52
ratio_analysischapter13.docx|
Ratio Analysis |
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In previous chapters, we presented many ratios used for evaluating the financial health and performance of a company. Here, we provide a summary listing of those ratios. (Page references to prior discussions are provided if you feel you need to review any individual ratios.) Appendix 13A provides an example of a comprehensive financial analysis employing these ratios.
LIQUIDITY RATIOS
Liquidity ratios (Illustration 13-16 ) measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity.
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Investor Insight
How to Manage the Current Ratio
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The apparent simplicity of the current ratio can have real-world limitations because adding equal amounts to both the numerator and the denominator causes the ratio to decrease.
Assume, for example, that a company has $2,000,000 of current assets and $1,000,000 of current liabilities. Its current ratio is 2:1. If it purchases $1,000,000 of inventory on account, it will have $3,000,000 of current assets and $2,000,000 of current liabilities. Its current ratio decreases to 1.5:1. If, instead, the company pays off $500,000 of its current liabilities, it will have $1,500,000 of current assets and $500,000 of current liabilities. Its current ratio increases to 3:1. Thus, any trend analysis should be done with care because the ratio is susceptible to quick changes and is easily influenced by management.
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How might management influence a company's current ratio?
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SOLVENCY RATIOS
Solvency ratios (Illustration 13-17 ) measure the ability of the company to survive over a long period of time. Long-term creditors and stockholders are interested in a company's long-run solvency, particularly its ability to pay interest as it comes due and to repay the balance of debt at its maturity.
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PROFITABILITY RATIOS
Profitability ratios (Illustration 13-18 ) measure the income or operating success of a company for a given period of time. A company's income, or lack of it, affects its ability to obtain debt and equity financing, its liquidity position, and its ability to grow. As a consequence, creditors and investors alike are interested in evaluating profitability. Profitability is frequently used as the ultimate test of management's operating effectiveness.
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Investor Insight
High Ratings Can Bring Low Returns
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Moody's, Standard and Poor's, and Fitch are three big firms that perform financial analysis on publicly traded companies and then publish ratings of the companies' creditworthiness. Investors and lenders rely heavily on these ratings in making investment and lending decisions. Some people feel that the collapse of the financial markets was worsened by inadequate research reports and ratings provided by the financial rating agencies. Critics contend that the rating agencies were reluctant to give large companies low ratings because they feared that by offending them they would lose out on business opportunities. For example, the rating agencies gave many so-called mortgage-backed securities ratings that suggested that they were low risk. Later, many of these very securities became completely worthless. Steps have been taken to reduce the conflicts of interest that lead to these faulty ratings.
Source: Aaron Lucchetti and Judith Burns, “Moody's CEO Warned Profit Push Posed a Risk to Quality of Ratings,” Wall Street Journal Online (October 23, 2008).
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Why are credit rating agencies important to the financial markets?
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RATIO ANALYSIS
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State whether each of the following is an indicator of a company's liquidity, solvency, or profitability.
Solution
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Related exercise material: BE13-10 , BE13-11 , BE13-12 , BE13-13 , BE13-14 , BE13-15 , 13-3 , E13-2 , E13-7 , E13-8 , E13-9 , E13-10 , E13-11 , E13-12 , and E13-13 .
