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Financial ratios are crucial for making sound investment decisions, mergers and acquisitions, and other business-related activities. These ratios are essential tools that allow us to quickly and easily analyze a company’s financial health. It is essential to understand the calculations of financial ratios and the underlying factors contributing to them. For example, a high current ratio may indicate that a company has a large amount of cash. Still, it could also mean the company carries excessive amounts of inventory or accounts receivable. Likewise, a lesser debt-to-equity ratio can show that an organization uses more Equity to finance its assets. However, it could also mean that the company needs to take advantage of potential tax benefits associated with debt financing.
Problem Description
As a business major, one of the essential skills one needs to have is the ability to understand and interpret financial statements (Hosaka, 2019). Balance sheet is one of the most familiar finacial statement. Balance sheet summarizes a company’s assets, liabilities, and Equity over a specific period of time. Consider the following scenario, Using the information provided, we will calculate critical financial ratios to help us understand the company’s liquidity, profitability, and solvency (Hosaka, 2019).
Table: ABC Corporation Balance sheet as of 31/12/2022
Solution
The first thing to do is the current ratio calculation. It effectively determines the Company’s ability to pay its current liabilities by utilizing its current assets. The effective manipulation is achieved through the division of current assets by the available liabilities. For our case analysis, the manipulation is achieved as shown below.
Current RatioRatio = Current Assets Divided by Current Liabilities
It means that for every $1 of current liability, ABC Corporation has $2 of current assets to cover it. A current ratio of 2 is generally considered healthy, indicating that the company can pay its short-term debts. The next thing to do is to calculate the debt-to-equity ratio. It measures the debt and equity proportion used to finance a company’s assets. It is calculated by dividing total liabilities by total Equity. In this case, the debt-to-equity RatioRatio is:
It means that for every $1 of Equity, ABC Corporation has $0.81 of debt. A debt-to-equity ratio of 0.81 is generally considered low, indicating that the company uses more Equity than debt to finance its assets (Awaysheh et al., 2020). Finally, the return on Equity (ROE) is calculated. It is a measure of how efficiently a company is using its Equity to generate profits. It is calculated by dividing net income by total Equity (Awaysheh et al., 2020). Assuming the net income information is $20,000 since the value is unknown. The ROE is:
It means that for every $1 of Equity, ABC Corporation is generating $0.19 of net income. An ROE of 19% is generally considered good, indicating that the company is generating profits efficiently.
By calculating these financial ratios, we can see that ABC Corporation is in a healthy financial position. The current ratio’s value is 2, which indicates that it can pay its short-term debts. A debt-to-equity ratio of 0.81 indicates that it uses more Equity than debt to finance its assets. An ROE of 19% indicates that it is generating profits efficiently. The problem descriptions and solution is thus a perfect classical example of how mathematical skills are applicable in deriving solutions to various business problems.
References
Awaysheh, A., Heron, R. A., Perry, T., & Wilson, J. I. (2020). On the relation between corporate social responsibility and financial performance. Strategic Management Journal, 41(6). Web.
Hosaka, T. (2019). Bankruptcy prediction using imaged financial ratios and convolutional neural networks. Expert Systems with Applications, 117(1), 287–299. Web.
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