Solved! The five types of financial ratios

What are the five types of financial ratios? Determine specific limitations associated with the identified ratio types.

Expert A+ Answer

Liquidity These types of ratios may be used to analyze the firm’s financial ability to meet short-term liabilities. This form of liquidity analysis focuses on the relationship between current assets and current liabilities, as well as the speed with which receivables and inventory can be converted into cash during normal business operations. This class of ratios is particularly important to bankers. Liquidity ratios in general are used extensively to qualify loan applicants for loans. Bankers view both the trend and the point-in-time peer group comparative measurements to be important.

Leverage- A company’s leverage ratio measures how much debt the firm has on its balance sheet. Leverage ratios represent another measure of financial health. Generally, the more debt a company has, the riskier its stock is. This escalating risk comes from two primary impacts that accompany higher debt: (1) the firm’s breakeven point goes up because of the higher fixed costs associated with the debt, and (2) the volatility of return on equity becomes less predictable and more volatile when debt increases.

Management Efficiency-This ratio essentially measures how many times a company “turns over” its accounts receivable during the course of the year. If accounts receivable turnover is too low, it indicates the company is being too generous granting credit or is having difficulty collecting from its customers. All else equal, higher receivables turnover is better.

Profitability Some of the management efficiency ratios are measurements of the firm’s ability to generate sales given its asset size. These ratios don’t address how much of the sales turn into profit. A firm that can generate substantial sales but cannot turn those sales into profits is not generating any returns for its owners. Profitability ratios focus on a firm’s ability to generate earnings as compared to its direct expenses and other relevant costs. These types of ratios are usually calculated at different “levels” of the income statement to evaluate the firm’s efficiency at different stages of the process.

Market Ratios- If the firm has equity that is publicly traded, one can use market ratios to get an indication of how the market values the firm versus peers (cross-sectional) or relative to its own historical performance (time-series). Because the price of equity is determined by market supply and demand forces, management can be evaluated on how the market views their performance; market value ratios give management an idea of what the firm’s investors think of the firm’s performance and future prospects.

(Gibbons, G. et al. (2015).

Determine specific limitations associated with the identified ratio types.

To identify a limitation of any ratio, the intended use must also be specified. A ratio is a simple equation that provides a percentage; what is use or how the ratio is used can vary greatly. The ratio of left to right foot socks in a drawer can be helpful for a person wanting to know if they have lost or misplaced any socks; however, to a person that doesn’t have a practical application or to this ratio proves irrelevant.

Liquidity- [Current Ration = Current Assets / Current Liabilities] The frequency and speed of the receivables play the leading role in this ratio as the conversion into cash in a business day.

Leverage- [Debt to Equity = Short Term Debt + Long Term Debt / Total Shareholder’ Equity] Simply put, it’s how much debt is carried by the entity. Too much leverage and the entity can become solvent by overextending themselves with other funding lines other than earnings.

Management Efficiency- [Accounts Receivable Turnover = Sales / Accounts Receivable.] When a request to purchase a new piece of industrial equipment, this formula can be useful. If the current piece(s) of industrial equipment is being over/underutilized, the justification for purchasing a new piece of equipment will be easy or difficult.

Profitability- [Operating Margin = Operating Income (EBIT) / Sales.] This ratio has multiple uses. It also can be used in the home as a budget. Yes, that’s a simplified use of the ratio but generates the same outcome.

Market Ratios- [Price per Share / Earnings per Share] Like the profitability ratio, this can hold a place in the household budget by knowing the market ratio. The price per banana has value, as does the price per share of investment.

Offer your peers a link to a video or an article that complements your answer to the items above.

I’m a visual learner and retain it much easier and faster if I see it performed or perform it myself. I found this YouTube video useful and thought you might also.

References

MBAbullshitDotCom. (Aug 16, 2013).  3 Minutes! Financial Ratios & Financial Ratio Analysis Explained & Financial Statement Analysis. YouTube. https://www.youtube.com/watch?v=TZZFBkbC2lA&t=5s

Gibbons, G., Hisrich, R. D., & DaSilve, C. M. (2015). Entrepreneurial finance: A global perspective. https://content.uagc.edu/books/Gibbons.4210.18.1/sections/navpoint-29?search=ratio#w14960

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