Question

Individuals performing ratio analysis include (1) banks evaluating potential loan applications from small businesses, (2) investment analysts evaluating the investment quality of a firm’s stock, and (3) internal management, assessing the firm’s current strengths and weaknesses. Select one of the three parties above, and for that party, identify which of the five ratio groups (liquidity, activity, debt, profitability, or market) would be of most value and which would probably be of least value. Explain the reasons behind your choices.

Answer 1

Answer.

3. Internal Management, assessing the firm's current strength and weaknesses

The internal management anlyse the internal resources and evaluate the performance of the company and its strength and weaknesses from time to time to make major strategic decisions and its future growth and expansion. The ratio analysis of the company's financial position gives an overall analysis of the company in market and against its competitors. The most valuable ratios to access the company's current strenght and weaknesses will be liquidity ratios, activity ratios and profitibility ratios.

The liquidity ratios, such as Current ratios and Acid Test ratios are used to evaluate the firm's ability to convert its assets into cash and pay off its debts as and when due.They are called short term solvency ratios as they provide the short term cash generating postion of company as and when required.

In addition, activity ratios such as inventory turnover ratios, debtor's turnover ratios & average collection period and Asset turover ratios are also evaluate the efficiency of various operations and effective utilization of current asset to to generate revenue and to payoff the current liabilities of the company.

Also, profitibility ratios asses company's ability to generate income from its assets and pay the expenses and cost of various investments. Ratios such as return on equity, return on assets, earning per share, gross profit ratios and net profit ratios evaluates how effectively owner's funds have been utilised to generate revenue for the company and its market position.