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Interpretation of Main Financial Ratios

Business owners want to determine their ability to pay short-term debt or to establish their immediate short-term liquidity. Dealing with a fast paced environment is critical for decision making, especially if it involves decisions that will have a long lasting impact.

The types of financial ratios are:
    1. Liquidity
      Activity
      Profitability
      Coverage.

    Liquidity ratios measure a company's ability to respond to request for sources to pay its current debt at a given time. Liquidity ratios include: Current Ratio, Quick or Acid Test Ratio, and Current Cash Debt Ratio. Current Ratio is the result of dividing current assets by current liabilities. The higher the ratio, the more liquid the company. The Quick Ratio demonstrates the strength or weakness of a company from the financial perspective. It is calculated by subtracting inventories from current assets and dividing the result by current liabilities. Current cash debt is the result of dividing net cash provided by operating activities by the average of current liabilities.

    Activity ratios measure liquidity of inventory and receivables and how well assets are used to generate sales. Activity ratios include: Receivable Turnover Ratio, Inventory Turnover Ratio, and Asset Turnover Ratio.

    Profitability ratios measure profitability of assets, owners' investment, net income earned on each share of common stock, the measure of the ratio of the market price per share to earnings per share, and the percentage of earnings distributed in the form of cash dividends.

    Coverage ratios measure the percentage of total assets provided by creditors, the ability to meet interest payments as they are due, the company's ability to repay its total liabilities out of its operations in a given year, and the amount of money each share of common stock would receive if the company were liquidated at the amounts reflected on the balance sheet.

    Forensic accountants analyze financial ratios of corporations and then compare them to the rates of similar companies where the organization operates. To access these reports usually involves charges depending on the size of the market to be analyzed. Reports are available by sales size range, number of employees, and other factors that highlight how the corporation being analyzed positions itself within the market or how far away its financial ratios are from its peers. If a company's financial ratios are unusual or distinct from the rest of companies to which a benchmark is established, forensic accountants determine first the justification or lack of it and then, they take action, if necessary.
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