Tools for Business Decision Making, Essay Example

Financial analyses can be broken down into three main categories that provide important insight into the company’s financial successes or failures.  These categories are liquidity ratios, solvency ratios and profitability ratios.  Liquidity ratios measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.  Solvency ratios measure the ability of the company to survive over a long period of time based on its earning potential and long-term or total debt.  Finally, Profitability ratios measure the income or operating successes or failures of company for a given period of time (Kimmel, Weygandt & Kieso, 2008).

An important liquidity ratio is called the Current Ratio.  This ratio is calculated by dividing current assets by current liabilities.  The Current Ratio is widely used for evaluating a company’s liquidity or its ability to pay its short-term debts.  However, this ratio can sometimes be misleading because the organization counts Office Supplies or Inventory as current assets when in fact these cannot be used directly to pay off a company’s current liabilities.  Therefore, it is often best to calculate the Current Cash Debt Coverage Ratio to measure a company’s true ability to pay its short-term debts.

The Debt to Total Assets Ratio is a critical Solvency ratio that measures the percentage of total financing provided by creditors.  This ratio is calculated by total liabilities by total assets.  If the calculations provide a higher percentage, this means that the company is often in a higher risk to be unable to meet its financial obligations, and this will put much more stress on the company’s creditors for investing in the organization.  If the ratio is lower, the company has more equity available to creditors if it would be determined that the organization is insolvent.

Finally, a popular Profitability ratio is called the Return on Assets Ratio.  This ratio is calculated by dividing Net Income by Average total assets.  This ratio is able to provide an overall financial analysis on the profitability of assets in terms of the income earned on each dollar invested in assets.  If this ratio does not tell enough of the profitability story, the Profit Margin ratio is often used to determine the amount of Net Income that is generated through each dollar of Net Sales; therefore, it is calculated by dividing Net Income by Net Sales.

References

Kimmel, P.D., Weygandt, J.J., & Kieso, D.E. (2008). Financial accounting: tools for business decision making. Boston: John Wiley & Sons, Inc.