Using Financial Ratios - Essay Example

The current ratio in the previous financial year indicates that the liabilities have increased during the year or some assets have been sold. Similarly, the current ratio can be used to make comparisons with similar businesses. For example, a steel manufacturer may have a current ratio of 2 while another has a current ratio of 1.5. Thus, the current ratio of the former is higher but it may also be due to a lot of unused assets affecting its profitability.

Gross Margin, which is a profitability ratio and is the ratio of gross profit to sales, makes a lot of sense for competitor analysis. Higher gross margins as compared to other companies in similar business lines indicate a healthy position of the firm. Similarly, a comparison with past periods is important. For manufacturing industries, the gross margins generally reduce over time and it is the volumes that drive the profitability (Analyzing your financial ratios).

Price Earnings (P/E) Ratio is the most widely used investment ratio. An increased price-earnings ratio as compared to past years may indicate a positive outlook for the company but if the ratio increases above a certain limit say 20, it indicates overheating and the chance of immediate correction in the stock price. A continuously decreasing P/E ratio may indicate bad stock fundamentals. Similarly, comparisons with similar companies can be used by an investor to make a rational investment decision (Drake, Pamela P).

The inventory Turnover ratio is a widely used investment ratio. It is the ratio of the Cost of Goods sold to an average inventory and indicates the speed of replenishment of stock. An increased inventory turnover ratio over previous years implies better inventory management and faster sales. However, it could also be due to lower production due to some issues. Similarly, comparison with similar businesses can be used to analyze whether the company has been able to catch up with consumer demand for its products (How to Analyze Your Business Using Financial Ratios).