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Financial ratios: the merits and ratios are important to bankers

What are the merits of the following financial ratios:

Profitability Ratio
Liquidity Ratio
Debt Ratio
Asset Activity Ratio
Market Values Ratio

What do these financial ratios tell us about a firm?

Why is it important to understand what these ratios mean to both a bank and an investor?

Solution Preview

Profitability Ratios:

Profitability ratios measure how successfully a business earns a return on its investment. These ratios include operating profit margin, net profit margin, return on assets and return on equity. Profit margins measure how much a company earns relative to its sales. Rate of return ratios in general measure the performance relative to some measure of size of the investment. By using these ratios, investors and banks can compare the efficiency of the firms and their returns before and after the impact of interest and tax expenses so that they can judge the financial strength of any firm. They can calculate the ratios for the same firm over several successive years to see if the company earnings are consistent, growing, or declining.

They can also compare their candidate's ratios to other companies in the same industry so that they will be able to determine where the firm stands in the industry. These ratios are easy to calculate and the information is readily available in a company's annual report. All they need do is review the income statement and balance sheet to come up with the data to plug into the formulas below:

1. Operating profit margin: (Earnings before interests and taxes)/sales
(Measures earnings before interests and taxes)

2. Net profit margin: (Earnings after taxes)/sales
(Measures earnings after taxes)

3. Return on Assets (ROA): (Earnings after taxes)/ (Total assets)
(Tells investors how well management is performing on all the firm's ...

Solution Summary

The 953 word solution presents good explanations for the various categories of ratios including their uses and benefits to organizations.