Financial Ratio Analysis: Management and Accounting

Subject: Case Studies
Pages: 2
Words: 557
Reading time:
3 min
Study level: Bachelor

The process of examining the connection between two or more elements of financial data from a statement of financial position is known as financial ratio analysis. Jim’s Auto Body firm is utilized as a reference to measure the financial health of the bicycle repair sector in this research. With the aid of the current ratio and return on capital employed (ROCE), the company’s liquidity and profitability are assessed.

Current Ratio

Liquidity ratios are designed to give users an idea of an institution’s short-term situation and if the business has utilized its short-term assets efficiently. The current ratio, for example, is computed by dividing current assets by current liabilities (Baraja & Yosya, 2019). According to Baraja and Yosya (2019), a business can determine how much of its current obligations can be serviced by current assets by dividing total current assets by total current liabilities. For example, according to Jim’s Auto Body’s balance statement for April 2018, the firm had $136,500 in assets and $8,500 in total liabilities. Therefore, Jim’s Auto Body Corporation’s current ratio for the period is as shown below. While the permissible limit of current ratios differs by industry, a ratio greater than three, as in Jim’s Auto Body (16.05), may suggest that the company is not utilizing its current assets efficiently or is not managing its cash flow appropriately.

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Current ratio= Current Assets/Current Liabilities =136,500/8,500 =16.06%

ROCE

ROCE, one of the profitability ratios used for this objective, may illustrate how organizations utilize their capital effectively by assessing the net profit earned in proportion to the capital used. According to the ROCE calculations, Jim’s company makes greater use of its capital. In other words, it can extract considerable earnings from every dollar of capital used (Kazi, 2020). It is determined by dividing net operating profit by capital employed (total assets minus current liabilities). According to Kazi (2020), a high ROCE score suggests that a greater portion of earnings may be reinvested in the firm for the benefit of shareholders. Reinvested money is reintroduced at a greater rate of return, resulting in stronger earnings-per-share growth. ROCE calculation as per Jim’s financial statement is as indicated below.

ROCE= Earnings before Interest and Taxes (EBIT) *100

Total assets-Current Liabilities

= (31,500/136,500-8,500) *100 = (31,500/128000)*100 =0.246*100 =24.6%

Reason for Choosing the Ratios

Short-term financial health is ensured by liquidity while long-term viability is assured through profitability. Both are required for any business to survive. In the perspective of an asset, liquidity denotes the asset’s eventual convertibility into cash. Therefore, the current ratio measures a company’s capacity to earn enough cash to pay off all of its obligations when they come due. It is widely used across the world to assess a company’s financial condition and performance.

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ROCE, on the other hand, is a financial ratio that is used to determine profitability. Several reasons may make investors not wish to utilize both ROCE and current ratio to inform their investment selections. For instance, the data needed to construct the two financial ratios, are taken from the balance sheet, which is a collection of historical data. As a result, they might not always present an accurate future performance. However, while current ratios only examine short-term achievements, as for Chief Financial Officer [CFO], ROCE is the best acceptable ratio to utilize, as it evaluates both short-term and long-term triumphs a firm may have.

References

Baraja, L., & Yosya, E. A. (2019). Analysis the impact of liquidity, profitability, activity and solvency ratio on change in earnings. Indonesian Management and Accounting Research, 17(1), 1-17. Web.

Kazi, M. (2020). Return on capital employed (ROCE). Financial Edge. Web.