Bus fin ch.4 concept

Ratio analysis involves analyzing financial statements to help appraise a firm's financial position and strength.

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The current and quick ratios both help us measure a firm's liquidity. The current ratio measures the relationship of the firm's current assets to its current liabilities, while the quick ratio measures the firm's ability to pay off short-term obligations without relying on the sale of inventories.

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Although a full liquidity analysis requires the use of a cash budget, the current and quick ratios provide fast and easy-to-use estimates of a firm's liquidity position.

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High current and quick ratios always indicate that the firm is managing its liquidity position well.

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If a firm sold some inventory for cash and left the funds in its bank account, its current ratio would probably not change much, but its quick ratio would decline.

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If a firm sold some inventory on credit, its current ratio would probably not change much, but its quick ratio would increase.

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If a firm sold some inventory on credit as opposed to cash, there is no reason to think that either its current or quick ratio would change.

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The inventory turnover ratio and days sales outstanding (DSO) are two ratios that are used to assess how effectively a firm is managing its current assets.

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A decline in a firm's inventory turnover ratio suggests that it is improving both its inventory management and its liquidity position, i.e., that it is becoming more liquid.

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In general, it's better to have a low inventory turnover ratio than a high one, as a low ratio indicates that the firm has an adequate stock of inventory relative to sales and thus will not lose sales as a result of running out of stock.

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