What is ratio analysis? Explain the four different types of ratios and how each is used.
What will be an ideal response?
Ratio analysis is the assessment of a firm's financial condition and performance through calculations and interpretation of financial ratios developed from the firm's financial statements. Financial ratios are especially useful in analyzing the actual performance of the company compared to its financial objectives and compared to other firms within its industry.
Liquidity ratios measure a company's ability to turn assets into cash to pay its short-term debts. These short-term debts are of particular importance to lenders of the firm who expect to be paid on time. Two key liquidity ratios are the current ratio (current assets divided by current liabilities) and the acid-test ratio (cash + accounts receivable + marketable securities divided by current liabilities).
Leverage ratios measure the degree to which a firm relies on borrowed funds in its operations. The debt to owners' equity ratio measures the degree to which the company is financed by borrowed funds that must be repaid (total liabilities divided by owners' equity).
Profitability ratios measure how effectively a firm is using its various resources to achieve profits. Company management's performance is often measured by the firm's profitability ratios. Three of the more important ratios used are earnings per share (net income after taxes divided by number of common stock shares outstanding), return on sales (net income divided by net sales), and return on equity (net income after tax divided by total owners' equity).
Activity ratios measure the effectiveness of a firm's management in using the assets that are available. The inventory turnover ratio (cost of goods sold divided by average inventory) measures the speed of inventory moving through the firm and its conversion into sales.
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