Financial accounting ratios Essay.

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Details:Describe how you would use a large number of ratios to perform a complete ratio analysis of a firm. Discuss the pros and cons of these ratios. Reference Principles of Managerial Finance, 12th Edition, 2009 ISBN: 0-321-52413-6 Author Lawrence J. Gitman



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Analysis of financial ratios. Economist and firm owners use financial ratios to either gauge the performance of a firm over a period of time or compare and contrast the performance with regards to other firms they bench-mark with. These ratios are broken down are broken down to main categories as;


            Profitability ratio. These ratios are used by stakeholders and other investors to evaluate the firm financial success overtime. First, the most widely used profitability ratios are; return on sales/net profit margin ratios; this ratio is used to measure the bottom-line profitability of a firm. Second, operating margin; this ratios measures both production and non-production cost of a firm .Third, gross profit margin; which measures the production cost of a firm. Fourth, return on assets ratio measures how firm assets are used effectively to realize profit. Lastly, return on equity ratio is used by investors and stakeholders; it shows the net return of an organization per dollar invested (Vance pg. 4-160).


            Advantages are; helps the investors and stakeholders in comparing the performance of their firm with others, it help in outlining the firm crucial information in a straightforward and a simple way, the owners of the firm uses the trend information in predicting the future of the company and other projections and finally, facilitates the understanding of a firm financial statements with simplicity (Vance pg. 4-160).


            Disadvantages are; first, though these ratios can be used as a tool for comparing the performance of the firm and other firms, we cannot ignore the fact that different companies operate in different environmental conditions and the structure, second, in most cases ratios evaluate the past performance and neglecting the future performances, therefore, they might not be very useful to already investors (Vance pg. 4-160).


            Assets utilization ratios these ratios are used to measure how effective the firm management is; it serves as a guideline of how the firm utilizes its inventory, assets and account receivable. An example of such ratio is assets turnover ratio; it is used to show how the firm assets are properly utilized with the goal of generating sales revenue. The other ratio is fixed assets turnover ratio; measures fixed assets associated with direct production than current assets. Inventory turnover ratio; is a ratio that is used to measure how effective a firm manages its inventory; it is calculated by dividing total amounts of goods sold and dividing by average inventory. Day sales outstanding ratio it measures the duration a firm takes in collecting the amount it had issued on credit sales; it is calculated by adding all the account receivable and dividing the results by net credit sales and the results multiplied by 365 (Bragg  27).

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