We know that investors and stock analysis make regular use of an organization’s financial documents to assess its worth. These documents can be analyzed by managers as planning and decision making aids.
Managers often want to examine their organization’s balance sheet and income statements to analyze key ratios, ratio that is to compare two significant figures from the financial statements and express them as a percentage or ratio. This practice allows managers to compare current financial performance with that of previous periods and other organization in the same industry. Some of the more useful ratios evaluate liquidity, leverage operations and profitability.
What are liquidity ratios? Liquidity is a measure of the organization’s ability to convert assets into cash in order that debts can be met. The most popular liquidity ratios are the current ratio and the acid test ratio.
The current ratio is defined as the organization’s current assets divided by its current liabilities. Although there is no magic number that is considered safe the accountant’s rule of thumb for the current ratio I.2:1 A significantly higher ratio usually suggests that management is not getting the best return on its asset. A ratio at or below 1:1 indicates potential difficulty in meeting short term obligations (accounts payable interest payments, salaries taxes and so forth).
The acid test ratio is the same as the current ratio except that current assets are reduced by the dollar value of inventory held. When inventories turn slowly or are difficult to sell, the acid test ratio may more accurately represent the organization’s true liquidity. That is, a high current ratio heavily based on an inventory that is difficult to sell overstates the organization’s true liquidity. Accordingly accountants typically consider an acid test ratio of 1:1 to be reasonable.
Leverage ratios refer to the use of borrowed funds to operates and expand and organization. The advantage of leverage occurs when funds can be used to earn a rate of return well above the cost of those funds. For instance, if management can borrow money at 8 percent and can earn 12 percent on it internally, it makes good sense to borrow, but there are risks to over leveraging. The interest on the debt can be a drain on the organization’s cash resources and can, in extreme cases, drive an organization into bankruptcy. The objective therefore, is to use debt wisely Leverage ratios such as debt to assets ratios (computed by dividing total debt by total assets) or the interest earned ratio (computed by dividing total debt by total assets) or the times interest earned ratio (computed as profits before interest and taxes divided by total interest charges) can help managers control debt levels.
Operating ratios describe how efficiently management is using the organization’s resources. The most popular operating ratios are inventory turnover and total assets turnover. The inventory turnover ratio is defined as revenue divided by inventory. The higher the ratio, the more efficiently inventory assets are being used. Revenue divided by total represents an organization’s total assets turnover ratio. It measures the level of assets needed to generate the organization’s revenue. The fewer the assets used to achieve a given level of revenue, the more efficiently management is using the organization’s total assets.
Profit making organizations want to measure their effectiveness and efficiency Profitability ratios serve such a purpose. The better known of these ratios are profit margin on revenues and return on investment.
Mangers of organizations that have variety of products want to put their efforts into those products that are most profitable. The profit margin on revenues ratio, computed as net profit after taxes divided by total revenues, is a measure of profits per dollar revenues.
One of the most widely used measures of business firm’s profitability is the return on investment ratio. It’s calculated by multiplying revenues / investments by profits / revenues. This percentage recognizes that absolute profits must be placed in the context of assets required to generate those profits.