Financial
Financial
Michael De Furia
Doctor Zhenhn Jin
Managerial Finance MBA 6010
16 January, 2011
Assignment # 4 (Week 1 Final Project)
Financial ratios are a valuable and easy way to interpret the numbers found in statements. It can help to answer critical questions such as whether the business is carrying excess debt or inventory, whether customers are paying according to terms, whether the operating expenses are too high and whether the company assets are being used properly to generate income.
When computing financial relationships, a good indication of the companys financial strengths and weaknesses becomes clear. Examining these ratios over time provides some insight as to how effectively the business is being operated.
Many industries compile average industry ratios each year. Average industry ratios offer the small business owner a means of comparing his or her company with others within the same industry. In this manner, they provide yet another measurement of an individual companys strengths or weaknesses. Robert Morris & Associates is a good source of comparative financial ratios. Following are the most critical ratios for most businesses, though there are others that may be computed.
Current Ratio: The current ratio gauges how capable a business is in paying current liabilities by using current assets only. Current ratio is also called the working capital ratio. A general rule of thumb for the current ratio is 2 to 1 (or 2:1 or 2/1). However, an industry average may be a better standard than this rule of thumb. The actual quality and management of assets must also be considered.
Quick Ratio: Quick ratio focuses on immediate liquidity (i.e., cash, accounts receivable, etc.) but specifically ignores inventory. Also called the acid test ratio, it indicates the extent to which you could pay current liabilities without relying on the sale of inventory. Quick assets are highly liquid and are immediately convertible to cash. A general rule of thumb states that the ratio should be 1 to 1 (or 1:1 or 1/1). By removing inventory, the quick ratio does a good job of filtering out the uncertainty that that is present in the current ratio by only including assets that are truly easier to turn into cash. This is a more conservative way of analyzing the cash position of a company; the quick ratio is often referred to as the “acid test”. While the quick ratio is more targeted at understanding true liquidity, it doesnt fit that bill 100%. Notice the AR, or accounts receivables portion in our formula below. Again, a company may or may not receive those funds or may have to settle for less than the