What are the uses of ratio analysis for stakeholders?

Answer 1

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http://falcon.jmu.edu/~gallagsr/ratioforman.pdf

1 ©Scott Gallagher 2004
Gallagher on Financial Ratio Analysis
Ratios derived from the financial statements of firms are an important management tool.
Analogous to someone’s vital statistics, heart rate, cholesterol level, blood pressure, etc.
ratios can provide valuable insights into and empirical support for strategic issues
surrounding firms.
There are a large number of potential ratios. As a manager you will have to use your
discretion to identify which ones are the most important or meaningful given the
situation. Keep in mind as well that different accounting assumptions or outright
manipulation can skew financial ratio comparisons both within and between companies.
Therefore, using ratio analysis in isolation can be problematic.
For simplicity we’ll group ratios into three common areas, profitability, activity, and
solvency. The calculation of any ratio is an elementary school math problem. The extent
of the challenge embodied in financial ratios is using them effectively to understand their
implications on the performance and future of the firm.
Performance Ratios. These ratios are concerned with how well the firm is using its
assets and the investments of stakeholders, especially the firm’s shareholders. Common
ratios used as performance measures have income as the numerator and include:
Return on Assets = Net Income / Assets
Return on Equity = Net Income / Shareholders Equity
Profit Margin = Net Income / Sales (or Revenue)
Earnings per Share = Net Income / Shares of Common Stock
The larger each of these ratios are the better the firm is performing. While historical or
industry level data is exceptionally useful for comparison, other metrics can be used. For
example, for any year a firm’s return on assets should be greater than the risk free rate of
return. Earnings per share is not really a performance ratio but it can be helpful,
especially with new firms, because it takes account of new issues of stock. Make sure
this number is computed on a fully diluted basis.
Activity Ratios. These ratios provide an indication of how well a firm’s resources are
being used by management. Common activity ratios include:
Asset Turnover = Sales / Total Assets
Days’ Receivables = Accounts Receivable / (Average Day’s Sales = Sales / 365)
Inventory Turnover = Cost of Goods Sold / (Average Inventory = (starting INV + ending
INV)/2) You can also compute day’s inventory as = 365 / Inventory Turnover
Working Capital Turnover = Sales / (Avg. Current Assets – Avg. Current Liabilities)
As before, the higher the better. Days’ receivables is one of the best indicators in the
absence of historical or industry comparison data because any number over 90 indicates
that the firm is not being very efficient in collecting its debts. Inventory turnover is also
2 ©Scott Gallagher 2004
especially helpful because it indicates how liquid a firms inventory is. In industries
where the value of products depreciates rapidly, e.g. personal computers, a low number
here can indicate an important problem.
Solvency and Leverage Ratios. Probably the most well known and closely watched of
the ratios, these ratios indicate the long run viability of the firm. Insolvency can quickly
lead to bankruptcy, and so rating agencies such as Standard and Poor are frequently very
keen on these ratios. Common solvency ratios include:
Current Ratio = Current Assets / Current Liabilities
Quick or Acid Test Ratio = (cash + marketable securities) / current liabilities
Debt Ratio = Total Debt (or liabilities) / Total Assets
Debt to Equity = Total Debt (or liabilities) / Owner’s Equity
Times Interest Earned = (Pretax Operating Income + Interest Expense) / Interest Expense
Unlike before, higher is not always better. It is especially important that the current ratio
be greater than one. Recall that current refers to things occurring within the accounting
year. Therefore, a current ratio lower than one calls for immediate management
attention, either to liquidate non current assets or to arrange for some sort of financing or
equity issue. Debt ratios of larger than one are potentially of concern because they
indicate that the company could not meet its debt obligations if it sold off all of its assets.
While not intrinsically bad, higher debt ratios suggest higher leverage and the resulting
higher returns and larger risks that companies with them undertake. Times interest
earned is not really a solvency ratio but rather how durable the company will be to
adversity. A high ratio here suggests the ability for the firm to weather a downturn and
still meet its obligations.
Using Ratios. The key is not calculating the ratios but using them to help you in your
analysis of why firm performance differs. For example, if Wal-Mart has a great
inventory system where and how would that be reflected in its financial ratios? If a
company has high debt and appears to be entering a downturn when should you be
alarmed?
Obviously ratios, just like our personal vital statistics, have the most value when
compared to industry averages and prior periods. However, looking to ratios can start
you on your search of finding valuable firm resources and empirically demonstrating the
value of resources or capabilities you’ve identified in your analysis. In addition, where
you think they me applicable you should devise ratios of your own, e.g. percentage of
sales by region or sales by product line.
Finally, for 487, keep in mind that the Business Strategy Game uses a number of these
ratios as the basis for your score. Therefore, your grade for the game is a direct result of
these types of ratios. A better understanding of them can help you understand how your
game score is determined.

Answer 2

Ok so you are a student of virtual university and trying to cheat on MGT501 quiz. This has been reported to your HRM teacher. The answers however are : Question No. Correct Option 1. A 2. B 3. B 4. C 5. B 6. D 7. A 8. C 9. B 10. B 11. A 12. D 13. B 14. D 15. D 16. A 17. D 18. D 19. C 20. C

Answer 3

what are the challenges of using current ratios