Ratio analysis compares the line-item data in a firm's financial statements, which will reveal many understandings regarding liquidity, profitability, operational efficiency, and solvency. Moreover, r
Rodgers wrote:
As indicated in the chapter, we can classify ratios into three types for analysis of the primary financial statements:
Liquidity ratios. Measures of the short‐term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
Solvency ratios. Measures of the ability of the company to survive over a long period of time.
Profitability ratios. Measures of the income or operating success of a company for a given period of time.
As a tool of analysis, ratios can provide clues to underlying conditions that may not be apparent from an inspection of the individual components of a particular ratio. But, a single ratio by itself is not very meaningful. Accordingly, in this discussion we use the following three comparisons. (Tools for Business Decision Making, p.666)
What are the most important ratios from the 3 categories and why?
The most important ratio under Liquidity Ratio is Current ratio because it expresses the relationship of current assets to current liabilities.
The most important ratio under the Solvency ratio is Debt to asset ratio because it measures the percentage of total financing provided by creditors.
The most important ratio under Profitability ratio is Profitability ratio because this ratio measures the income or operating success of a company for a given period of time.
Reference:
Accounting: Tools for Business Decision Making. Paul D. Kimmel; Jerry J. Weygandt; Donald E. Kieso (6th ed.).
Denise wrote:
Ratio analysis is used to evaluate a company’s liquidity, solvency and profitability by comparing line items (e.g. cash, inventory, short-term debt, etc.) in the financial statements. There are three categories of ratios: liquidity, solvency and profitability ratios; these are composed of a series of equations that help analyze the data in each category.
Liquidity ratios measures the company’s ability to pay its short-term obligations. It can be used by the company to measure its financial health. The most important (and most used) liquidity ratio is the quick ratio (or acid-test ratio); it will help investors and lenders to decide whether to invest in the company.
On the other hand, solvency ratios measure the company’s ability to pay its long-term obligations. It helps the company to measure how much debt is supporting the business and/or decide whether to finance operations with debt or equity. The most commonly used solvency ratio is the debt to equity ratio which provides warning to lenders (if a company has a significant amount of debt it might not be able to pay its obligations).
Finally, we have profitability ratios which determines the ability of a company to create profit. This ratio can be used by the company to compare it with others in the industry as well as to look for trends in order to budget and forecast. Gross profit margin is the most important profitability ratio. It shows how much a company is making on profit taking into consideration the production cost also assessing the company’s performance.
Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2015). Accounting Tools for Business Decision
Making (6th ed.). Retrieved from The University of Phoenix eBook Collection database.
AccountingTools. (2019). Retrieved from https://www.accountingtools.com/
Investopedia. (2014). Retrieved from https://www.investopedia.com/
