Ratio Analysis Essay Example | Topics and Well Written Essays - 750 words

Ratio Analysis - Essay Example Suppose we want to assess the financial health of a very large or small firm, how can we analyze the firm so our analysis can provide an insight into the basic prospects for profitability of a firm? Is the firm losing or is it profitable? Are there prospects for making the firm profitable? Is the firm worth buying? Should we sell the firm? If we are to sell the firm, at what price should our purchase price be? How large are the firm’s debts? What are its prospects for profitability? What is the firm’s net worth? These are some of the questions in which ratio analysis can help provide an answer. Gibson (1982, p. 18) pointed out that the financial â€Å"ratios can be grouped into four categories: liquidity, debt, profitability, and other† financial ratios. The liquidity ratios include the working capital ratio, and the current ratio (Gibson 1982, pp. 18-19). Some of the broad debt ratios include the debt-to-capital and the debt-to-equity ratios. The debt-to-capital ratios used by many firms include the long term debt-to-long term debt plus stockholders’ equity, short term debt plus long-term debt-to-short term debt plus long-term debt plus stockholders’ equity, and several other ratios (Gibson 1982, p. 22). ... It also plausible that ratios can be devised based on one’s objectives although there are financial ratios that are conventionally or more popularly used to assess firm performance and status. As pointed out by Gibson (1982, p. 22), for example, â€Å"firm executives have many different opinions on how a firm debt position should be determined from the balanced sheet.† Profitability ratios include measures for earnings per share, return on equity, profit margin, return on capital, return on assets, gross margin, pre-tax margin, and operating margin (Gibson 1982, p. 23). Each type of ratio on profitability can include several specific types of measures. For example, the specific measures or ratios for profit margin include net income-to-sales, income from continuing operations-to-sales, income before minority share-to-sales, net income-to-total revenues, income before extraordinary item-to-sales, income from continuing operations and before extraordinary item-to-sales, a nd income before cumulative effect of change in accounting principle-to-sales (Gibson 1982, p. 24). The tone of Gibson (1982) indicates that a financial analyst may improvise ratios or measures as long as they are helpful to analysis but there are ratios that are conventionally or more popularly used by analysts for assessing liquidity, profitability, debt, or other aspects of firm or business operations. The formulas of the more popular ratios are contained in financial and accounting textbooks. Meanwhile, the ratios identified by Gibson (1982) for drawing insights on firm or business operations include dividend per share, book value per share, effective tax rate, dividend payout, price earnings ratio, and labour per hour. However, surely there are other measures that can be developed depending