Question

QUESTION 4:
A. In learning about ratios, we could simply study the different types or categories of ratios, or we could use ratios to answer some important questions about a firm's operations. We prefer the latter approach and have chosen the following four questions as a map in using financial ratios:
1. How liquid is the firm?
2. Is management generating adequate operating profits on the firm's assets?
3. How is the firm financing its assets?
4. Are the owners (stockholders) receiving an adequate return on their investment?

Answer 1

1. How liquid is the firm

Liquidity ratios can be used to understand how liquid the firm is

The major liquidity ratios are - Current Ratio and Quick Ratio - the higher the ratio, the better the liquidity

Current ratio is calculated as the ratio of current assets to current liabilities

Current Ratio= Current Assets/ Current Liabilities

It measures the capability of the firm to pay off the current liabilities (liabilities within one year)

Liquid ratio, also known as acid test ratio is a more stringent ratio, where only cash and cash equivalents, marketable securities, accounts receivable are used within current assets

Liquid ratio= Cash + Marketable Securities+ Accounts receivables/ Current liabilities

2. Is management generating adequate operating profits on the firm's assets?

Profitability ratios determine whether the firm is generating adequate profits on assets - a higher ratio means more return for the stakeholders.

The major ratio in this case is Return on assets ratio

Return on assets = Net income/ Average total assets

Net income is the gross income minus all the cost of goods sold, all overheads, depreciation, interest and taxes.

Average total assets considers total assets at the start and end of the financial year and divided by 2 to take out average. Only historical cost and not depreciated cost is considered.

3.  How is the firm financing its assets?

Debt to asset ratio is used to understand the amount of total assets that are financed by creditors instead of investors. This shows how the company is leveraged. Both creditors and investors would look at this ratio to make their respective decisions. Higher ratio would normally mean a more risky proposition, as more interest will have to be paid out. A ratio of less than 1 denotes that the company can pay off its debts through its assets.

Debt to Asset ratio = Total debt/ Total assets

4. Are the owners (stockholders) receiving an adequate return on their investment?

Return on investment ratio is used to understand the returns that the investors are making on their investment. This ratio is widely used by analysts and investors to calculate the return on investments

ROI = Net profit/ Total investment *100

For example, if we have a stock of a company purchased at $100 and the value has now risen to $110, this means the return on investment is 10 % i.e. $10/ $100*100