Individuals performing ratio analysis include (1) banks evaluating potential loa
ID: 2711414 • Letter: I
Question
Individuals performing ratio analysis include (1) banks evaluating potential loan applications from small businesses, (2) investment analysts evaluating the investment quality of a firm’s stock, and (3) internal management, assessing the firm’s current strengths and weaknesses. Select one of the three parties above, and for that party, identify which of the five ratio groups (liquidity, activity, debt, profitability, or market) would be of most value and which would probably be of least value. Explain the reasons behind your choices.
Explanation / Answer
1)
Banks evaluating potential loan applications from small businesses:
Ratio analysis should involve analysing the Net assets (Total Asset-Total liabilities) of the bank to ensure that the loan amount will be paid back.
The most valuable ratio would be debt ratio, which will tell how much of the total asset has been financed by debt.Any is the firm has sufficient Net asset to finance the new debt. Liquidity and profitability ratio is also important as it will tell about the quality of the asset and the future growth opportunities.
Thus the least valuable would be activity ratio
2)
Investment analysts evaluating the investment quality of a firm’s stock:
Ratio analysis should involve analysing the return on the investment. Return on the investment directly defpends on the profitability of the firm.
The most valuable ratio would be Profitability ratio. Activity ratio, debt ratio impacts the profitability of the shareholder directly. Higher the activity ration and higher the debt ratio, higher will be EPS.
The Least valuable would be liquidity ratio
3)
Internal management, assessing the firm’s current strengths and weaknesses
Ratio analysis would involve analysing the quality of management like inventory turnover ratio, average collection period etc, which all are activity ratio
The most valuable ratio would be activity ratio
The least valuable would be the market as the management has no control over the market upturn and downturn.