Ratio and Financial Statement Analysis - Essay should critically analyze the ben
ID: 2701507 • Letter: R
Question
Ratio and Financial Statement Analysis - Essay should critically analyze the benefits and limitiations of ratio analysis, explaining what factors impact the meaningfulness of such measures and what new practices or theories may be emergeing regarding the application of ratio and financial statement analysis. This should emphasize practical applications and real world use of ratios synthesizing the reading in publised research or survey articles (Relevant Text Material: Parrino - Chapeters 3 & 4).
Explanation / Answer
The four major ratio measurements that users of the financial statements perform to gauge the effectiveness and efficiency of a company%u2019s management are liquidity, activity, profitability, and coverage. But you may be asking, isn%u2019t an investor interested only in how profitable a company is? Not necessarily.
Liquidity, which is how well a company can cover its short-term debt; activity, which shows how well a company uses its assets to generate sales; and coverage, which measures the degree of protection for long-term debt, are all measurements that have to be considered along with profitability to form a complete picture of how well a business is doing.
This ratio tells you the company%u2019s ability to pay current debt without having to resort to outside financing. Let%u2019s say you%u2019re looking at a company%u2019s balance sheet. Current assets are $100,000 and current liabilities are $45,000. The current ratio is 2.2 ($100,000 / $45,000). In this case, the company has sufficient current assets to pay current liabilities without going to outside financing.
The acid test ratio is similar to the current ratio, but it includes only quick assets. Wait, what the heck is a quick asset? A quick asset is readily convertible to cash or is already in the form of available cash %u2014 think money in the company%u2019s operating checking account.
To figure the acid test ratio, you first add together cash, temporary cash investments (like stock in other companies that the business plans to sell within one year of the balance sheet date), andaccounts receivable. Then you divide that total by the company%u2019s current liabilities.
Turnover analysis shows how quickly income-producing assets such as merchandise inventory comes in and goes back out the door. The quicker, the better! In normal circumstances, efficiently moving assets indicates a well-run business. Therefore, the asset turnover ratio measures how efficiently a company uses its assets to generate sales.
The basic formula for calculating asset turnover is net sales divided by average total assets. If net sales are $135,000 and average total assets are $87,500, asset turnover is 1.54 times. In other words, the company earns $1.54 for each $1 it invests in assets. That turnover ratio looks pretty good, but to truly give this ratio meaning, you have to compare it to asset turnover for similar companies.
This activity measure shows how efficiently the company is handling inventory management and replenishment and how fast the products are being sold. The less inventory a company keeps on hand, the lower its costs are to store and hold it. This strategy lowers the cost of inventory that must be financed with debt or owners%u2019 equity, or the ownership rights left over after deducting liabilities.
To compute this ratio, divide the cost of goods sold by average inventory. Suppose that the cost of goods sold is $35,000 and average inventory is $8,500. Inventory turnover is 4.12 times ($35,000 / $8,500). Again, comparing this inventory turnover figure against industry averages, the higher the ratio, the better!
This ratio shows the average number of times accounts receivable (A/R) is turned over %u2014 that is, booked and paid %u2014 during the financial period. The sooner a company collects receivables from its customers, the sooner the cash is available to take care of the business%u2019s needs.
Why is this such a big deal? Well, the more cash the company brings in from operations, the less it has to borrow for timely payment of its liabilities.
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