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Ratio Analysis

Ratio Analysis

Introduction

In this paper, we will discuss the profitability, liquidity, and solvency ratios that affects acompany. The limitations of ratios and bench marking capabilities. Along with three questions that would provide good information about what ratios are important, which ones are important to internal management and which ones are important to the creditors. The reader would have a better understanding of each of the items that will be discuss in this paper.

Probability Ratio

The probability of an outcome for a particular event is a number telling us how likely a particular outcome is to occur. This number is the ratio of the number of ways the outcome may occur to the number of total possible outcomes for the event. Probability is usually expressed as a fraction or decimal. Since the number of ways a certain outcome may occur is always smaller or equal to the total of outcomes, the probability of an event is some number from 0 through 1.

An example of a probability ratio would be as follows: Suppose a regular dice is rolled. What is the probability of getting a 3 or a 6? There are a total of 6 possible outcomes.

Rolling a 3 or a 6 are two of them, so the probability is the ratio of 2/6 = 1/3. Website: http://www.mathleague.com/help/percent/percent.htm Retrieved on February10, 2009.

Liquidity Ratios

Common liquidity ratios include the current ratio, the quick ratio and the operating cash flow ratio. Different analysts consider different assets to be relevant in calculating liquidity.

Some analysts will calculate only the sum of cash and equivalents divided by current liabilities because they believe that they are the most liquid assets, and would be the most likely to be used to cover short-term debts in an emergency. A company's ability to turn short-term assets into cash to cover debts is of the utmost importance when creditors are seeking payment. Bankruptcy analysts and mortgage originators frequently use the liquidity ratios to determine “whether” acompany will be able to continue as a going concern. This website was retrieved on February 10, 2009: http://www.investopedia.com/terms/l/liquidityratios.asp .

Solvency Ratio

One of many ratios used to measure a company's ability to meet long-term obligations. The solvency ratio measures the size of a company's after-tax income, excluding non-cash depreciation expenses, as compared to the firm's total debt obligations. It provides a measurement of how likely a company will be to continue meeting its debt obligations. The measure is usually calculated as follows: Acceptable solvency ratios will vary from industry to industry, but as a general rule of thumb, a solvency ratio of greater than 20% is considered financially healthy. Generally speaking, the lower a company's solvency ratio, the greater the probability that the company will default on its debt obligations.

Limitations of Ratios Analysis

Accounting Information has different policies that has choices that may change company comparisons. Like for instance, the business may opt not to revalue its asset because by doing so the depreciation charge is going to be high and will result in lower ...

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