Question

Discuss what each of the following ratios can tell you about a company’s financial results.

​1)Profit Margin

​2) Capital Asset Turnover

​3) Quick Ratio

​4) Times Interest Earned

How much information do the ratios alone give you? What should the ratios be benchmarked against? What are the limitations of ratio analysis?

Answer 1

1. Profit Margin is the degree of income earned in relation to the revenue. It is simply expressed as the profits in relation to the sales or service revenues earned.
2. Capital Asset Turnover: it is the value of company's revenues ie sales and services in relation to its capital assets. It is the efficiency of company in using its assets for earning the revenue.
3. Quick ratio: This ratio tells us the efficiency of the company to pay the current liabilities without selling its inventory. It is expressed as current liabilities divided by current assets other than Inventory. The best quick ratio is 1:1.
4. Times Interest Earned: It is the number of times the Interest is covered by the Pre tax operating income. This ratio tells us the ability of the company to meet its debt obligation using its income.

Ratio helps us with the information useful to mark the performance and compare this performance with the metrics of the industry and competitors. It also helps us in generating various metrics in simplest form of performance of the organisation.

Ratios can be benchmarked against:

• It's own performance in the previous year
• The budget
• The industry metrics
• Competitor's ratios

Limitations of ratio analysis:

• If the financial statements itself are window dressed, the ratios may lead to incorrect results.
• Financial ratios don't help us with information relating to qualitative aspects.
• Some ratios are defined differently in different ways.
• Ratios help in identifying the problem and not solving it.