Financial Ratios

    The current ratio tests the liquidity of a company. It is calculated by dividing the current assets by the current liability. The ratio tells us the proportion of the current assets that are available for the company to cover the current liabilities that it has (Loth, 2012). The ratio ascertains whether the short term assets of a company can readily pay off the short term liabilities. Cash, marketable securities, inventory, receivables, and cash equivalents are all short term assets. Payables, taxes, accrued expenses, current portion of term debt, and notes payable are all short term liabilities. This ratio is frequently used in financial reporting because it is important for a company to have enough current assets to cover its current liabilities. The ratio is important to banks because short-term creditors should prefer a higher current ratio as it means reduced risks for the bank. The ratio is important for investors to understand because if a company has a lower current ratio, it is an indicator that the company is using more of their assets to grow the business (Internet Center for Management and Business Administration, Inc. , 2012).

The quick ratio is calculated by finding the sum of a company’s liquid current assets minus inventory and dividing those by current liabilities. It is much like the current ratio but excludes inventory. The higher the ratio, the more liquid that a company is thought to be. The current assets that are used to calculate the ratio cash, notes receivable, and accounts receivable. Banks can use this formula when determining whether a company is a good candidate for a loan. A good candidate is one who is low risk. Investors need to understand the quick ratio because it can help them to determine the likeliness of the company to yield a high return (Quickratio.org, 2011).

The debt ratio is a company’s total debt divided by its total assets. The ratio indicates the long term solvency of a company (Internet Center for Management and Business Administration, Inc. , 2012). The ratio can be important to banks because the measure how much and to what extent a company is using long term debt. It also measure the company’s ability to repay any long term debt they may have. Investors need to know the meaning of the ratio because it will help them in determining the company’s level of risk based of its financial health.

The return on equity ratio measure how profitable a company is. It is calculated by dividing the net income by the shareholder equity. Investors would be wise to understand the ratio because it is essentially the bottom line measurement of profits earned per dollar invested. It tells investors exactly how much their dollar is earning them. The higher the rate of return on equity, the more efficient that a company’s management has been in utilizing the equity base. It is important for banks to understand the return on equity ratio because it is a profitability indicator that can show just how well a company is doing (Kulkarni, 2011). This could also be used to mitigate risk when trying to decide whether or not to extend a line of credit to a company.

References

Internet Center for Management and Business Administration, Inc. . (2012). Finance. Retrieved from Financial Ratios: http://www.netmba.com/finance/financial/ratios/

Kulkarni, A. (2011). Buzzle.com. Retrieved from Return on Equity Ratio: http://www.buzzle.com/articles/return-on-equity-ratio.html

Loth, R. (2012). Investopedia. Retrieved from Current Ratio: http://www.investopedia.com/university/ratios/liquidity-measurement/ratio1.asp#axzz1qF6PNKt1

Quickratio.org. (2011). Quickratio.org. Retrieved from The Importance of Quick Ratio: http://www.quickratio.org/