Question

Most decision makers and analysts use five groups of ratios to examine the different aspects of a company’s performance. Indicate whether each of the following statements regarding financial ratios is true or false.

Statement	True	False
A   company exhibiting a high liquidity ratio is likely to have enough resources   to pay off its short-term obligations.
Asset   management or activity ratios provide insights into management’s efficiency   in using a firm’s working capital and long-term assets.
Debt   or financial leverage ratios help analysts determine whether a company has   sufficient cash to repay its short-term debt obligations.
One   possible explanation for an increase in a firm’s profitability ratios over a   certain time span is that the company’s income has increased.
Market   value or market based ratios help analysts figure out what investors and the   markets think about the firm’s growth prospects or current and future   operational performance.

Answer 1

Statement	True	False
A   company exhibiting a high liquidity ratio is likely to have enough resources   to pay off its short-term obligations.
Asset   management or activity ratios provide insights into management’s efficiency   in using a firm’s working capital and long-term assets.
Debt   or financial leverage ratios help analysts determine whether a company has   sufficient cash to repay its short-term debt obligations.
One   possible explanation for an increase in a firm’s profitability ratios over a   certain time span is that the company’s income has increased.
Market   value or market based ratios help analysts figure out what investors and the   markets think about the firm’s growth prospects or current and future   operational performance.

Answer 2

A high liquidity ratio implies that the company has enough money to pay off its short-term liabilities and will have no difficulty running its operations. A low liquidity ratio is a negative signal, implying that the company cannot pay off its short-term obligations and that it will have difficulty running its operations.

Asset management or activity ratios help analysts develop insights into management’s efficiency in using its working capital and long-term assets. Examples of these ratios—such as the days’ sales outstanding or average collection period, and the inventory, fixed asset, and total asset turnover ratios—provide insights into how efficiently the company is collecting cash from its receivables and using its assets to generate sales, respectively.

Debt or financial leverage ratios indicate whether a company has sufficient cash to repay its long-term—not its short-term—debt obligations. In addition, a ratio in this category, the times-interest-earned ratio, can help analysts assess a firm’s ability to service its debt (that is, both pay the interest and repay the principal on its long-term debt obligations). Other ratios, such as the debt ratio and the debt-to-equity ratio, indicates the extent to which a firm relies on debt and equity financing.

One possible explanation for an increase in a firm’s profitability ratios over a certain time span is that the company’s income has increased. Examples of profitability ratios include profit margins, such as net profit margin and gross profit margin, which are calculated by dividing a firm’s net or gross profits by its sales, respectively. Assuming that the firm’s sales remain constant or increase more slowly than the increase in its profits, then its profit margin will exhibit an increasing trend.

Market value or market based ratios help analysts figure out what investors and the markets think about the firm’s growth prospects or current and future operational performance. One example of this class of ratios is the market-to-book ratio. If the market-to-book ratio for a company’s stock is less than its competitors’ comparable ratios, then this indicates that the market is looking less favorably at the company relative to its peers. This lower market-to-book ratio might reflect the market’s concern about the firm’s sales growth prospects or its relative inefficiency compared with its peers.