Provide a 1 page analysis while answering the following question: What comparisons do the calculations of financial ratios enable us to make Take two of these comparisons, and say why the process enab

Provide a 1 page analysis while answering the following question: What comparisons do the calculations of financial ratios enable us to make Take two of these comparisons, and say why the process enables management to make better decisions. Prepare this assignment according to the guidelines found in the APA Style Guide. An abstract is required. Various types of financial ratios can be effectively used to make comparisons and enable management to make better informed decisions. Here, past period and similar business are the two comparisons used for analysis. Examples of liquidity, profitability, investment and efficiency ratios have been cited to support the analysis.

Current ratio, which is a liquidity ratio and is equal to the ratio of current assets to current liabilities, can be used to make a comparison with the past period. For example, if the current ratio in the previous financial year was 1.6 and has decreased to 1.1 in the current year, it may a matter of concern. It indicates that the liabilities have increased during the year or some assets have been sold. Similarly, current ratio can be used to make comparisons with similar business. For example, a steel manufacturer may have a current ratio of 2 while another has the current ratio of 1.5. Thus, current ratio of the former is higher but it may also be due to a lot of unused assets affecting its profitability.

Gross Margin, which is a profitability ratio and is the ratio of gross profit to sales, makes a lot of sense for competitor analysis. Higher gross margins as compared to other companies in similar business lines indicate healthy position of the firm. Similarly a comparison with past periods is important. For manufacturing industries, the gross margins generally reduce over time and it is the volumes that drive the profitability (Analyzing your financial ratios).

Price Earnings (P/E) Ratio is the most widely used investment ratio. An increased price earnings ratio as compared to past years may indicate positive outlook for the company but if the ratio increases above a certain limit say 20, it indicates overheating and chance of immediate correction in the stock price. A continuously decreasing P/E ratio may indicate bad stock fundamentals. Similarly, comparisons with similar companies can be used by an investor to take a rational investment decision (Drake, Pamela P).

Inventory Turnover ratio is a widely used investment ratio. It is the ratio of Cost of Goods sold to average inventory and indicates the speed of replenishment of stock. An increased inventory turnover ratio over previous years implies better inventory management and faster sales. However, it could also be due to lower production due to some issues. Similarly, comparison with similar businesses can be used to analyze whether the company has been able to catch up with consumer demand for its products (How to Analyze Your Business Using Financial Ratios).

References:

‘How to Analyze Your Business Using Financial Ratios’, Available online February 22, 2012 from Drake, Pamela P.