External users and analysts rely on publicly-available information to perform financial analysis
Such information is contained in corporate annual report
Annual Report Contents FOUR BASIC FINANCIAL STATEMENTS FOOTNOTES TO THE FINANCIAL STATEMENTS SUMMARY OF ACCOUNTING METHODS MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL STATEMENTS AUDITOR’S REPORT COMPARATIVE FINANCIAL DATA FOR A SERIES OF YEARS 1 2 3 4 5 6
The acid-test (quick) ratio measures the quick assets—cash, short-term investments, and receivables—to current liabilities. This ratio excludes inventory and prepaid expenses because these current assets are the least liquid current assets.
Certain ratios measure the firm’s ability to sell inventory and collect receivables , a key factor in a firm’s success.
Inventory turnover measures how many times a year the company sells its average level of inventory. A high turnover indicates relative ease of selling inventory, while a low turnover indicates relative difficulty of selling inventory.
Accounts receivable turnover measures how quickly the firm collects cash from credit customers. The higher the ratio, the more quickly a firm collects its receivables.
Days’ sales in receivables is the number of days ’ sales that remain uncollected.
Suppose you were analyzing Company A and Company B and the two companies reported the following:
Company A Company B
Current assets $10,000 $10,000,000
Current liabilities 5,000 9,995,000
Working capital $ 5,000 $ 5,000
Both companies have identical working capital, but which company has a better ability to pay its short-term debt?
Company A, because the ratio of the current assets to current liabilities is higher for Company A. Working capital is not a ratio; it does not calculate the relative size of the current assets to current liabilities. The current ratio provides a better understanding of the two companies’ liquidity.
Current ratio of A is 2 ($10,000 $5,000) Current ratio of B is 1.001 ($10,000,000 $9,995,000)
No one ratio or year’s worth of financial information should be relied upon to provide a complete assessment of a corporation’s financial condition
Ratio analysis is most helpful when calculated over a broad time frame and when used in conjunction with other relevant information that can affect a company, such as legislation, competition, and scandals.