Financial Ratio Analysis

Categories: Business Financial Analysis Ratio Analysis

Analysis, Pages 3 (745 words)

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Financial ratio analysis is conducted by managers, equity investors, long-term creditors and short-term creditors. What is the primary emphasis of each of these groups in evaluating ratios? Managers deal with all types of ratios. It is important for them to judge and improve the overall financial position of the company. Financial ratios are one of the most common tools of managerial decision making. Financial ratios involve the comparison of various figures from the financial statements in order to gain information about a company's performance.

Ratios to this group, serve as indicators, clues, or red flags regarding noteworthy relationships between variables used to measure the firm's performance in terms of profitability, asset utilization, liquidity, leverage, or market valuation.

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Equity Investors use the analysis of financial ratio to help equity investors know whether their investment earnings some return or not. They emphasize more on profitability ratios with those investors look for entities with high earning potential and will be reluctant to associate themselves one that poor return since the market price of stock and dividend potential will be adversely affected.

Long-Term Creditors deal mostly with the solvency ratios.

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They are important because the ratios under this category indicate the long term financial position of the company in terms of its solvency. Financial ratios analysis helps long term creditors to know company’s ability to meet interest expenses and long term obligations on time. Times interest earned ratio, debt to total assets turnover ratio, debt to shareholders equity ratio are also some of the ratios that are helpful for long term creditors.

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Short-term Creditors find liquidity ratios as more important.

The analysis of financial ratios assists Short term creditors to know the ability of company to pay their short term obligation. They mainly focus on corporate liquidity is especially important to creditors. If a company has poor liquidity position, it may lead to delay in receiving interest and principal payments or even losses on the amounts due. It includes various calculated ratios such as Current ratio, receivable turnover, accounts payable , liquid ratio, working capital etc. , that helps short term creditors analyze company’s credit history. (3-3)

Over the past years, M. D. Rryngaert & Co. has realized an increase in its current ratio and drop in its total assets turnover ratio. However, the company’s sales, quick ratio, and fixed assets turnover ratio have remained constant. What explains these changes? It may have been that the inventory of M. D. Rryngaert & Co. was not properly managed. We can witness that because of a higher inventory, current assets increases, with an automatic decrease in total assets turnover. However, the quick ratio and the fixed assets turnover have remained constant due to the fact that they are not included in inventory.

Furthermore, with sales remaining constant and with an increase in inventory as mentioned, the company is definitely not in a good financial position. (3-4) Profit margins and turnover ratios vary from one industry to another. What differences would you expect to find between a grocery chain such as Safeway and steel company? Think particularly about the turnover ratios, the profit margin, and Du Pont equation. Safeway, being a grocery business, requires a lesser number of dollars in assets to produce a dollar in sales than would a steel company.

Furthermore the margin that grocery stores derive from the sale of each item is usually low. That is why they rely on a large volume of sales, and high turnover of inventory. They sell their products quickly, with a high turnover, and a lower profit margin with having to sell higher volumes of products to make up for the low margin. As for the steel company, being a business that has a higher profit margin but low turnover ratio, it tends to have lower volume of business transactions. The steel company would also spend more money in assets in order to generate a good return in sales, as compared to a grocery store.

The profit margin being the ratio between revenue and income, finds a business with higher profit margin to have lower cost of sales and hence high profit, while a business with lower profit margin will have higher cost of sales. Turnover ratios show how many times a year company is replacing their inventories. So by using the DuPont formula, we can calculate the ROA for each different company by a simpler version of the equation being Return on Assets (ROA) = Profit Margin x Total Asset Turnover.