Ratio analysis essay

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ratio analysis essay

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A high sales-to-fixed-assets ratio reflects efficient use of money invested in plant and in other productive or capital assets. Higher levels of management, as with investors, tend to look at overall profitability ratios as the standards by which their performance is judged Tamari,1978. Differing accounting methods much of the incomparability of financial statements between businesses can be traced to different accounting methods. The most striking differences occur in (1) inventory valuation (fifo, weighted average, etc.) (2) depreciation (straight-line, sum-of-the-years'-digits, etc.) (3) capitalization versus expense of certain costs,. Leases and developmentof natural resources (4) investments in common stock carried at cost, equity, and sometimes market (5) definition of discontinued operations and extraordinary items kieso and weygandt,1982. Examples of striking effects of accounting methods superior Oil Company owned.4 of Texaco, inc. Which was carried at a cost of 64 million, despite its market value of 118 million.

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Labor leaders pay particular attention to sources of increased wages and the strength and adequacy of pension plans (which tend to be chronically underfunded). Owners, shareholders and potential investors tend to be most interested in profitability. Many investors look for a high payout ratio (cash dividend/net income). Speculators pay more attention to stock statements value insofar as growth companies tend to have a low payout ratio because they reinvest their earnings. Bondholders are inclined to look for indicators of long-run solvency. Short-term creditors, such as bankers, pay special attention to cash flow and short-term liquidity indicators, such as current ratio. Both classes of creditors prefer lending to firms with low (usually no higher than 40-50) leverage ratios, such as debt to total assets. As indicated earlier, management can use financial statements for diagnostic purposes - with different managers paying attention to different ratios. A buyer may look closely at inventory turnover. Too much inventory may mean excessive storage space and spoilage, whereas too little inventory could mean loss of sales and customers due to stock shortages. A credit manager may be more interested in the accounts receivable turnover to assess the correctness of her credit policies.

Example of ratio table analysis use ratios are useful to indicate various symptoms. Usually those symptoms require more detailed analysis. For example, ratio analysis may reveal an increase in sales volume relative to inventory and receivables. But inventories could have increased less rapidly than sales due to reduced cost of goods, inability to replace inventory items, change in inventory policy or a change in inventory valuation. Receivables could have increased less rapidly than sales because of a more efficient collection policy, a larger proportion of cash sales or a change in policy with regard to the extension of credit. Sales volume could have increased due to plant expansion, an aggressive sales campaign, price increase, price decrease or extension of sales territories. Ratio changes lead managers to ask pointed questions. What different classes of statement users look for government officials are generally concerned that reporting and valuation regulations have been complied with - and that taxable income is fairly represented.

ratio analysis essay

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Yet it is questionable if this could be done without a write loss in operating capacity - especially serious in a recession. In the case of an airline, cash flows are more a function of its current assets than of its non-current assets. Examples of ratio variation between businesses a five-year average (1960-1964) of current ratio stands.56 for hardware stores,.95 for grocery stores,.11 for cotton cloth mills and.70 for building construction contractors. Note the variation between types of retailer and manufacturer. These industry standards are not unhealthy. Another interesting ratio is fixed assets (depreciated book value) per tangible net worth. Five year percentages for this ratio are.7 for manufacturers of womens' coats,.1 for manufacturers of bakery goods,.9 for grocery stores and.2 for furniture stores. In general, this ratio is best kept low for new businesses, which should rent land and buildings until the future of the business is ensured. Experience has shown that small businesses should attempt not to exceed 66 and large businesses should avoid exceeding 75 foulke,1968.

Oil, for example, can be rapidly liquidated, but inventories of service parts could take years to sell - hardly "current assets". Also, small businesses can often liquidate their inventories more rapidly than large ones, indicating that current ratio may not be comparable for different size firms. Moreover, the relative investment in inventory rose from 77 of working capital to 83 of working capital between 19 for American corporations Miller,1966. Just-In-Time (JIT) inventory control using computers has dramatically decreased the amount of inventory held. Thus, indicators from the past might not be useful for the future. A 1-to-1 "acid-test" ratio which excluded inventory from current assets was a suggested replacement for current ratio, but the liquidity of the receivables portion of current assets is still open to question without information on collectability. In a strike or a recession, the business might have to pay its current liabilities by liquidating its current assets.

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ratio analysis essay

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Service industries - such as railroads, airlines and public utilities - have less of a problem with flow of inventory. Their focus tends to be on balancing operating revenue against operating expenses dominated by fixed assets (depreciation, repairs, replacement, maintenance, etc.). Companies with high proportions of current assets tend to be financed through short-term borrowing and shareowner investment. Industrial corporations tend to be financed primarily through shareowners, whereas public utilities and railroads are more often financed by long-term borrowing (bonds) Holmes, et al,1970. Types of ratio analysis careful financial statement analysis usually means the extraction of meaningful ratios from the statements.

These ratios have been classified as measuring (1) liquidity (current ratio, acid-test ratio, etc.) (2) activity (receivables turnover, inventory turnover, etc.) (3) profitability (profit margin on sales, rate of return on assets, earnings per share, etc.) and (4) leverage (debt to total assets, times england interest. Ratios are often used to assess performance or as diagnostic tools to point up potential problem areas. Given the extremely varied entities for which financial statements are made - and even the extreme variation between industries of an entity type - the most productive use of these ratios is probably made either against industry standards or against ratios for previous years. Current ratio-the patriarch ratio current ratio (the ratio of current assets to current liabilities) was perhaps the earliest ratio to gain widespread use as a measure of solvency. On the theory that 2 in current assets could safely cover 1 of current liabilities (with enough remaining to operate) a 2-to-1 value became an inflexible standard. But inventories can vary greatly in their liquidities.

The statement of changes of financial position shows the sources and uses of a firm's financial resources, demonstrating trends in the alteration of its capital structure. The statement of retained earnings reconciles the owners' equity section of successive balance sheets, showing what has happened to generated revenue. Comparability of financial statements. Comparison of financial statements forms the basis for much financial analysis. Four main types of comparison are made: (1) comparison of statements for the enterprise between successive years (2) comparison of a firm's statements with those of a specific competitor (3) comparison of a firm against an industry standard and (4) comparison with a target, such as a company's budget. Comparisons between different organizations may be difficult or even meaningless because of differences in (1) size of the organization (2) type of organization and (3) accounting methods used by the organization.


Often, both the size and type of organization will dictate the kind of accounting methods used. Characteristics of entities having financial statements. Non-profit organizations such as government and charities typically present statements which exhibit their resources and the way those resources are distributed or held. Stewardship and responsibility are the focus for these statements. Financial statements for private individuals focus on resources and obligations - helping the person to assess his or her financial condition and to plan financial affairs (or obtain a bank loan) Rosenfield, 1981. Retailers are typically highly mortgaged, rely on credit to wholesalers (following a desire for a large and varied stock often offer extensive credit to customers (or no credit, on a strictly cash basis) and reside in high-rent locations. Wholesalers tend to be characterized by large inventories, large sales volume (with small profit margin) and chronic credit problems with retailers. Manufacturers tend to have a substantial investment in fixed assets (machinery, equipment and buildings) and often face major problems due to a large work-force costales,1979.

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Financial statements are summaries of monetary data about an enterprise. The most common financial statements include the balance sheet, the income statement, the statement of changes of financial position and the statement of retained earnings. These statements are used by management, labor, investors, creditors and government regulatory agencies, primarily. Financial statements may be drawn up for private individuals, non-profit organizations, retailers, wholesalers, manufacturers and service industries. The nature of the enterprise involved dramatically affects the kind of data available in the financial statements. The purposes of the user resume dramatically affects the data he or she warming will seek. Kinds of financial statements, the balance sheet provides the user with data about available resources as well as the claims to those resources. The income statement provides the user with data about the profitability of the enterprise detailing sources of revenue and the expenses which reduce profit.

ratio analysis essay

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Ratio analysis essay
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