Companies prepare three financial statements according to GAAP rules: the income statement, the balance sheet, and the cash flow statement. Identify the three main financial statements that companies generally submit
Profitability ratios are used to assess a business's ability to generate earnings. Compare the information given by calculating the various profitability ratios
Liquidity ratios measure how quickly assets can be turned into cash in order to pay the company's short-term obligations. Compare the current ratio to the quick ratio
One such ratio is known as the current ratio, which is equal to: Current Assets ÷ Current Liabilities. This ratio reveals whether the firm can cover its short-term debts; it is an indication of a firm's market liquidity and ability to meet creditor's demands. Acceptable current ratios vary from industry to industry. For a healthy business, a current ratio will generally fall between 1.5 and 3. If current liabilities exceed current assets (i.e., the current ratio is below 1), then the company may have problems meeting its short-term obligations. If the current ratio is too high, the company may be inefficiently using its current assets or its short-term financing facilities. This may also indicate problems in working capital management.The acid test ratio (or quick ratio) is similar to current ratio except in that it ignores inventories. It is equal to: (Current Assets - Inventories) Current Liabilities. Typically the quick ratio is more meaningful than the current ratio because inventory cannot always be relied upon to convert to cash. A ratio of 1:1 is recommended. Low values for the current or quick ratios (values less than 1) indicate that a firm may have difficulty meeting current obligations. Low values, however, do not indicate a critical problem. If an organization has good long-term prospects, it may be able to borrow against those prospects to meet current obligations. A firm may improve its liquidity ratios by raising the value of its current assets, reducing the value of current liabilities, or negotiating delayed or lower payments to creditors.Debt ratios provide information about a company's long-term financial health. Explain the methods and usage of debt utilization ratios
Debt Ratio = Total Debt / Total Assets For example, a company with $2 million in total assets and $500,000 in total liabilities would have a debt ratio of 25%. The higher the ratio, the greater the risk associated with the firm's operation. In addition, high debt to assets ratio may indicate low borrowing capacity of a firm, which in turn will lower the firm's financial flexibility. Like all financial ratios, a company's debt ratio should be compared with their industry average or other competing firms. The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. When used to calculate a company's financial leverage, the debt usually includes only the Long Term Debt (LTD). D/E = Debt(liabilities)/Equity. The debt service coverage ratio (DSCR), also known as debt coverage ratio (DCR), is the ratio of cash available for debt servicing to interest, principal, and lease payments. It is a popular benchmark used in the measurement of an entity's ability to produce enough cash to cover its debt (including lease) payments. The higher this ratio is, the easier it is to obtain a loan. In general, it is calculated as:DSCR = (Annual Net Income + Amortization/Depreciation + Interest Expense + other non-cash and discretionary items (such as non-contractual management bonuses)) / (Principal Repayment + Interest payments + Lease payments) A similar debt utilization ratio is the times interest earned (TIE), or interest coverage ratio. It is a measure of a company's ability to honor its debt payments. It may be calculated as either EBIT or EBITDA, divided by the total interest payable. EBIT is earnings before interest and taxes, and EBITDA is earnings before interest, taxes, depreciation, and amortization.Most financial ratios have no universal benchmarks, so meaningful analysis involves comparisons with competitors and industry averages. Explain how to effectively use financial statement analysis
The main purpose of conducting financial analysis is to measure a business's profitability and solvency. The actual metrics tracked and methods applied vary from stakeholder to stakeholder, depending on his or her interests and needs. For example, equity investors are interested in the long-term earnings power of the organization and perhaps the sustainability and growth of dividend payments. Creditors want to ensure the interest and principal is paid on the organizations debt securities (e.g., bonds) when due. Most analytical measures are expressed as percentages or ratios, which allows for easy comparison with other businesses in the industry regardless of absolute company size. Vertical analysis, which is a proportional analysis of financial statements, lists each line item in the financial statement as the percentage of another line item. For example, on an income statement each line item will be listed as a percentage of gross sales. This technique is also referred to as normalization or common-sizing. When using these analytical measures, one should take the following factors into consideration:
Identify the ratio analysis tools used for shares of stock
Activity ratios provide useful insights regarding an organization's ability to leverage existing assets efficiently. Calculate activity ratios to determine organizational efficiency
Most of the ratios discussed can be calculated using information found in the three main financial statements. Apply financial ratio analysis to Bounded Inc.
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