LC Complete week 4
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D41241355
Part 1
Week 4: Homework
Week 4: Quiz
Part 2 complete discussion
Just like with most tools, ratio analysis has benefits and limitations. Please discuss at least one benefit and one limitation of ratio analysis.
Part 3 reply to discussion
There are many benefits and limitations to the ratio analysis. First lets examine the ration analysis. There are five types
liquidity ratios, debt management ratios, Asset Management ratios, profitability ratios, and Market Value Ratios.
Lets examine several of the Liquidity ratios and discuss their benefits and limitations...
Current Ratio= Current assets/current liabilities. This according to what we read in lesson 4's reading this week gives us the number of times that the current assets have covered the current liabilities. We'd like to see high results greater than 1 which indicate that the organization has enough current assets to cover their current liabilities.
The liquidity ratio also covers the Quick ratio=(Current assets -inventory)/Current Liabilities. This ratio is similar but only to current ratio but only includes current assets that are easily liquidated (cash assets or can be liquidated if required)
Cash Ratio also falls into this category of liquidity ratios. it is as followed Cash Ratio= (cash=marketable securities)/Current Liabilities. Similar to the current ratio but it does not include accounts receivable as well as it does not include current inventory.
Now lets discuss the benefits and limitations of these 3 liquidity ratios. Some of the benefits include the ability to confidently decide for yourself in looking at the outcomes of these ratio's if the company has the ability to cover their debts (shorter term ones). If a company has a current ratio of less than 1 then I'd consider them in danger of failing to meet financial commitments and going under. If they scored a 2 in the current ratio it would show me, personally, that this company has enough assets and money invested to pay off their current liabilities.
Another great benefit to these liquidity ratios the ability to assess risk based on the outcomes of the ratios and their quantifiable analysis. When you have a company with a high ratio it shows that this company probably has investors comfortable and confident in lending to or investing in this company. You want to see a company with an high ratio which means they have enough liquidity within the company to provide themselves and their investors with financial security.
As with every benefit their are also limitations and drawbacks which we cant ignore. The issue with these liquidity ratios is that in a general sense, they're short term visuals of the company's overall financial health and no one really has the ability to predict the future. Liquidity ratios really only focus on these short term obligations of the company. The current ratio for example is great for showing short term profitability but in a long term sense you really have no way to assure anyone you can meet any long term debts you may incur. Markets change and fluctuate quickly and what can be a hot commodity now could surely become obsolete. When it comes to investing heavily and trying to predict long term profitability I like to remind people of the Tulips from 17th century Holland. Overnight people basically realized they were literally trading flowers. Stocks in these Tulip bulbs that were worth millions one day were crashed and worthless the next.
Another drawback to the liquidity ratios is that we don't include the quality of assets. They are all equal in the eyes of the ratios. In our case, (I work in metal manufacturing) We can have the same amount of globally sourced SCH 10 Stainless steel pipe on hand as I do SCH 10 Stainless Steel AIS (American Iron and Steel) pipe on hand. AIS is my fast mover and global is my slow mover. In the eyes of the ratio, they are valued the same.
Part 4 reply to discussion
Good morning Professor and Classs,
The benefits and demerits of using a ratio analysis include but not limited to the following:
1. It makes financial statements easier to understand.
2. It facilitates the comparison of businesses of various sizes.
3. It facilitates trend analysis, which compares a single business across time.
4. It rapidly highlights crucial facts in an easy-to-understand way. Instead of reading the complete financial accounts, a user might make a judgment on a company based on a few numbers.
Some of the drawbacks of using ratio analysis include the following:
Questions
- All of the data utilized in ratio analysis comes from real-world historical outcomes. This does not guarantee that the same outcomes will occur in the future'.
- Cost comparison between the past and present. While some components of the balance sheet may be given at historical cost, which may differ significantly from current costs, the information on the income statement is stated in current costs, or nearly so. Unusual ratio results may arise from this discrepancy.
3. The rate of inflation. The figures may not be comparable across eras if the rate of inflation has changed during any of the reviewed periods.
Questions
- A business may alter its fundamental operating framework to the point that a ratio determined a few years ago and would yield a false conclusion if compared to the same ratio today.
- Policies for recording the same accounting transaction may vary throughout firms. This implies that it can be like comparing apples and oranges to compare the ratio outcomes of various businesses.
6. Conditions of business. Ratio analysis must be seen within the broader business environment.
7. Interpretation. Determining the cause of a ratio's outcomes can be very challenging.
8. Business plan. Comparing two businesses that are following distinct strategies using ratio analysis might be risky.