Chapter 3 presents the concept of financial analysis through the use of ratios.

Question

Chapter 3 presents the concept of financial analysis through the use of ratios. The chapter presents 13 ratios in four categories. Briefly explain the four categories and discuss why they would be important in making a stock purchase. In preparing your comments, assume you have $10,000 to invest in the stock market and you are trying to choose between companies in the same industry. How would you use the ratios presented in chapter 3 to decide what stock to purchase? Why would you take the time and effort to calculate the ratios instead of seeking investment advice from a market analyst?

Classification System We will separate 13 significant ratios into four primary categories.

A. Profitability ratios

1. Profit margin

2. Return on assets (investment)

3. Return on equity

B. Asset utilization ratios

4. Receivable turnover

5. Average collection period

6. Inventory turnover

7. Fixed asset turnover

8. Total asset turnover

C. Liquidity ratios

9. Current ratio

10. quick ratio

D. Debt utilization ratios

11. Debt to total assets

12. Times interest earned

13. Fixed charge coverage

Explanation / Answer

Profitability ratios:

These ratios talk about the abilty of the firm to generate earnings and maintaining expenses so that the company is profitable

Liquidity ratio: These ratios focus on the firms ability to make short term interest payments and to sustain the day to day operations of the firm.Genrally focussed on the current assets and liabilities section of the balance sheet.

The higher the ratio the better the ability of the firm to meet its current obligations. Ratio less than 1 is a warning sign.

Asset utilization ratios:
AKA efficiency ratios. The ratios in this category talk about the efficiency with which the firm is utilizing its assets to generate revenue. Together they talk about how fast the company is generting revenue by selling its products, and how soon is it collecting the cash, and what is the average collection period.

Debt utilization ratios:
These ratio explain the ability of the firm to maintain its long term debt obligations. The ratios included in this category mostly deal with the Non-Current assets and Non-Current Liabilites of the firm.

Ratios in this category tell the story of the financial health of the company.

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