Use of financial ratios
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"Who can figure bankers?" Pehr Weisengraf mumbled as he returned to the office of his small candy manufacturing business, Professional Confectioners. "They're willing to lend money only to those business owners who don't really need it. If you can prove you don't need it, they'll throw it at your feet. Unfortunately, we need it, and we need it fast."
Pehr called Robert Peltzman, the company's part-time bookkeeper, to see if he could explain what the banker had been talking about when he rejected Pehr's request for $80,000 to purchase new candy-making equipment and to boost the company's working capital base. "They turned down my loan request," Pehr explained to Robert. "The banker had those copies of our financial statements that you've been sending her. She said that many of our financial ratios were way off what they should be. I've never even taken a business course much less an accounting course. I have no idea what she was talking about, but she did give me this," Pehr said, thrusting a piece of paper at Robert. "I don't know. It's all Greek to me."
Robert looked at the page and saw that the banker had calculated several financial ratios based on Professional Confectioner's most recent financial statements and had compared them to the industry average. Here's what he saw:
Ratio Last Year This Year Industry Average
Current Ratio 2.3:1 1.7:1 2.4:1
Quick Ratio 0.7:1 0.4:1 0.8:1
Debt Ratio 0.81:1 0.89:1 0.65:1
Debt to Net Worth Ratio 2.6:1 2.9:1 1.9:1
Inventory Turnover Ratio 4.9 times/year 4.3 times/year 7.1 times/year
Average Collection Period 36 days 43 days 34 days
Net Sales to Working Capital Ratio 10.4:1 9.7:1 12.6:1
Net Profit on Sales Ratio 4.1% 3.8% 9.4%
Net Profit to Equity Ratio 17.6% 18.3% 13.4%
"Can you tell me what this means, and more importantly, what we can do to improve our ratios so we can qualify for a loan?" Pehr said to Robert.
1. Answer Pehr's question to Robert.
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// To understand the ratio analysis from the perspective of a Banker, it is necessary to have clarity of concept regarding various ratio analysis techniques used by the Bankers. For answering the given query, it is necessary to go through the given scenario. So, firstly I am beginning with the importance and use of the' financial ratio'.//
1. Answer Pehr's question to Robert.
Use of financial ratios
To evaluate a firm's financial condition and performance, the financial analyst needs to perform "checkups" on various aspects of a firm's financial health. A tool frequently used during these checkups is a financial ratio, or index, which relates two pieces of financial data by dividing one quantity to the other (Horne, Wachowicz & Bhaduri, 2008).
The ratios are calculated to make a comparison that may prove to be more useful than the raw numbers. For example, suppose that a firm had a net profit figure of $1 million this year. That looks pretty profitable, but what if the firm has $ 200 million invested in total assets? By dividing the net profits by total assets, we get 0.005 ($1M/$200M), the firm's return on total assets (Horne, Wachowicz & Bhaduri, 2008). The 0.005 figure ...
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- MBA (IP), International Center for Internationa Business
- BBA, University of Rajasthan
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