What questions would you ask to decide how to weigh financial ratios when evaluating the financial health of an entity?

Answer 1

We can summarize an entity's financial condition by studying some of its key financial ratios. More than providing answers, ratio analysis helps in asking the right questions about a company's financial position. Is the firm profitable? What is the debt policy? How quickly can company use its own reserve? In the event of Joint Venture decision, ration analysis should consider compatibility in the financial makeup of two entities. Debt and borrowings affect risk and return. Debt increases financial risk and causes shareholders to demand a higher return on their investment. Financial distress occurs when promises to creditors are broken or honored with difficulty. Therefore, it is important to know and ask the debt to equity ratio of the company. The extent to which a company is in debt can be identified by evaluating its balance sheet. The notes disclose additional information that qualifies the company's debt position. If there is a substantial increase in inventory or accounts receivable, is there an associated buildup in Accounts Payable and short-term bank loans? If not, the firm may have to use long-term financing to carry part of the short-term needs. How are increases in long-term assets being financed? Most desirably, there should be adequate long-term financing and profits to carry these needs. If not, then short-term funds may be utilized to carry long-term needs. This is a potentially high-risk situation, in that short-term sources of funds may dry up while long-term needs continue to demand funding. The other question that would arise is how quickly the firm is turning over its accounts receivable, inventory and longer-term assets?