XACC 280 WK 7 - DQ 1 - 8049

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When it comes to liquidity, the ratio that I believe is the most important is the current ratio. The reason I chose the current ratio is because liquidity is used to calculate the short term abilities of a company to pay their growing obligations and their ability to pay for unanticipated needs.  The current ratio is a simple tool that evaluates just that by simply dividing the company’s current assets by their current liabilities.

The higher the ratio, the higher the liquidity of the company. According to
Weygandt, Kimmel, & Kieso (2008), “The current ratio is a more dependable indicator of liquidity than working capital. Two companies with the same amount of working capital may have significantly different current ratios.” When it comes to internal and external users, I think that this ratio is a well rounded number that all users can appreciate just the same. Investors want to know a company’s liquidity, along with other factors, so that they can make an informed decision as to their investments.

For profitability ratios, which are used to measure the operating success or income of a company, I believe the fastest and easiest way to do this is by figuring the return on assets. The return on assets is calculated by dividing the average assets into the net income.

The reason I believe this ratio is the most effective is because it gives a return on the company assets. This type of ratio can be used to see the profitability according to the company’s assets and their net income and not just their equity, profit margin, or asset turnover. The company’s management team can use this ratio to determine if their assets are bringing in enough income to make a reasonable profit margin for the company. If not, they can drop a specific product, or line of products to increase the return.

Solvency ratio, or the ability of a company to survive, is best calculated using the times interest earned. This is calculated by dividing the income before income taxes and interest expenses by the interest expenses. The simple truth of this equation is the company’s ability to pay their interest payments as they come due. The other ratio, debt to total assets ratio, only measures the percentage of total assets provided by the creditors and does not give the company’s ability to pay debt over time. Solvency, as stated earlier, is looking for the company’s ability to survive.

 

Instructors response.

Ratio analysis is a fantastic tool which can be used not only to review the financial statements of an organization, but also to compare the financial performance of an organization against its peers.  This type of comparison can lead to benchmarking and identifying key ratios for improvement in order to improve the performance to that of the peers being compared to.

Financial ratios can be broken down into the following categories:

Liquidity Ratios - measure the short term ability of the company to may its maturing obligations and meet unexpected needs for cash.
Profitability Ratios - measure the income or operating success of a company for a given period of time.
Solvency Ratios - measure the ability of a company to survive over a long period of time.

One key point to remember when working with financial statement ratios is all ratios are important in that each conveys its own information.  Different users of financial statements use different ratios, so the overall importance of a ratio is directly related to what the user is looking at.

 

Solution Description

When it comes to liquidity, the ratio that I believe is the most important is the current ratio. The reason I chose the current ratio is because liquidity is used to calculate the short term abilities of a company to pay their growing obligations and their ability to pay for unanticipated needs.  The current ratio is a simple tool that evaluates just that by simply dividing the company’s current assets by their current liabilities.