Ratio analysis and their significance

Ratios are quantitative tools that finance professionals use to analyse sets of financial information. A financial planner or analyst for example uses ratio as part of its tools in carrying out some duties like; business valuationbusiness analysis or even fundamental analysis.

Ratio analysis and their significance

BREAKING DOWN 'Current Ratio' A company with a current ratio less than one does not have the capital on hand to meet its short-term obligations if they were all due at once, while a current ratio greater than one indicates the company should be able to remain solvent in the short-term. For example, a company may have a very high current ratio but their accounts receivable are low quality.

Perhaps they have not been able to collect from their customers quickly which may be hidden in the current ratio. If inventory is unable to be sold, the current ratio may still look Ratio analysis and their significance, but the company may be headed for default. A current ratio that is less than one may seem alarming.

A current ratio less than one would not be concerning if the company has a much higher receivables turnover than payables turnover. For example, retail companies collect very quickly from consumers but have a long time to pay their suppliers.

Because of this imbalance, a current ratio below 1 is normal within the industry group. In theory, the higher the current ratio, the more capable the company is of paying its obligations because it has a larger proportion of short-term asset value relative to the value of its short-term liabilities.

However, a high ratio over 3 could indicate the company is not using its current assets efficiently, is not securing financing very well, or is not managing its working capital. Apple had more than enough to cover its current liabilities if they were all theoretically due immediately and all current assets could be turned into cash.

Limitations of 'Current Ratio' One limitation of using the current ratio emerges when using the ratio to compare different companies with one another. Businesses differ substantially between industries, therefore comparing the current ratios of companies across different industries may not lead to productive insight.

For example, in one industry it may be more typical to extend credit to clients for days or longer, while in another industry, short-term collections are more critical. Ironically, the industry that extends more credit may actually have a superficially stronger current ratio because their current assets would be higher.

It is usually more useful to compare companies within the same industry. Another drawback of using current ratios, briefly mentioned above, involves its lack of specificity.

For example, imagine two companies which both have a current ratio of. On the surface this may look equivalent but the quality and liquidity of those assets may be very different as shown in the following breakdown: In this example Company A has much more inventory than Company B, which will be harder to turn into cash in the short-term.

Perhaps this inventory is overstocked or unwanted, which may eventually reduce its value on the balance sheet. Company B has more cash, which is the most liquid asset and more accounts receivable which could be collected more quickly than inventory can be liquidated.

Although the total value of current assets match, Company B is in a more liquid, solvent position. The current liabilities of Company A and Company B are also very different.

Company A has more accounts payable while Company B has a greater amount of short-term notes payable. This would be worth more investigation because it is likely that the accounts payable will have to be paid before the entire balance of the notes payable account.

However, Company B does have fewer wages payable, which is the liability most likely to be paid in the short term. In this example, although both companies seem similar, Company B is likely in a more liquid and solvent position.

An investor can dig deeper into the details of a current ratio comparison by evaluating other liquidity ratios that are more narrowly focused than the current ratio.

Ratio analysis and their significance

A company that seems to have an acceptable current ratio could be trending towards a situation where it will struggle to pay its bills. Inversely, a company that may appear to be struggling now, could be making good progress towards a healthier current ratio.

Imagine two companies with a current ratio of 1. Based on the trend of the current ratio in the following table, which would analysts likely have more optimistic expectations for?

First the trend for Claws is negative, which means further investigation is prudent. Perhaps they are taking on too much debt, or their cash balance is being depleted: Cash asset ratio or cash ratio: Acid-test ratio or quick ratio: Operating cash flow ratio: These are usually defined as assets that are cash or will be turned into cash in a year or less, and liabilities that will be paid in a year or less.

Some weaknesses of the current ratio include the difficulty of comparing the measure across industry groups, overgeneralization of the specific asset and liability balances, and the lack of trending information.Financial ratio analysis compares relationships between financial statement accounts to identify the strengths and weaknesses of a company.

Financial ratios are usually split into seven main categories: liquidity, solvency, efficiency, profitability, equity, market prospects, investment leverage, and coverage. Types of Ratio analyis and their significance 1.

RATIO ANALYSIS Meaning of Ratio: A ratio is simple arithmetical expression of the relationship of one number to another. On the other hand, if their interest lays in the analysis of Profit trend the ratio that will interest to them are: Gross Profit on Sales, Net Profit on Sales, Net Profit to Capital Employed etc.

. solvency ratios, profitability ratios and leverage ratio and their significance. OBJECTIVES. After studying this lesson you will be able to: explain various types of accounting ratios i.e. solvency, profitability and leverage ratios; advantages of ratio analysis, it suffers from a .

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Ratio analysis and their significance

Meaning: Ratio analysis is the process of determining and interpreting numerical relationships based on financial statements. A ratio is a statistical yardstick that provides a measure of the relationship between two variables or figures.

. What is the 'Current Ratio' The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations. To calculate the ratio, analysts compare current.