When we calculate a ratio, all we get is a number. In order for this number to be meaningful, we need to put it into some kind of context by comparing it with another number. We can make these comparisons through: • Trend analysis of a single company by comparing current ratios to previous years’ ratios. Trends can be particularly useful in analyzing a firm’s financial condition. For example, ratios that are be-coming less favorable over time may be an indication of financial difficulty. The financial difficulty may not yet be apparent, but if the ratios do not improve, it will manifest itself in the future. Ratio analysis can thus provide an early warning of trouble ahead. • Comparison with other companies in the same industry or with industry averages after any necessary adjustments have been made to assure that the financial statements are comparable. If a company’s ratios are less favorable than those of other companies in its industry, the company will not be able to compete successfully in its market. • Comparison with management’s expectations. Ratios are classified into various categories based upon what they are measuring. The classifications that are used on the CMA exam are: • Liquidity ratios, which measure the sufficiency of the firm’s cash resources to meet its short-term cash obligations. • Leverage, capital structure, solvency and earnings coverage ratios, which evaluate the firm’s ability to satisfy its debt and obligations for other fixed financing charges such as operating leases by looking at the mix of its financing sources and its historical earnings. • Activity ratios, which provide information on a firms ability to manage efficiently its current assets (accounts receivable and inventory) and current liabilities (accounts payable). • Profitability analysis, which measures the firm’s profit in relation to its total revenue or the amount of net income from each dollar of sales and its return on invested assets. • Market ratios and earnings per share analysis, or shareholder ratios, which describe the firm’s financial condition in terms of amounts per share of stock.
Posted on: Sat, 20 Dec 2014 08:40:31 +0000
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