BUSS1030 Chap.7 Ratio Analysis for Business Decisions
Ratio Analysis for Business Decisions
Ratio analysis organises financial-statement evidence into liquidity, financial flexibility, profitability and operating-capability questions. This chapter calculates current, quick, debt, return and turnover ratios, then reopens each fraction to identify the account movement behind the result. Comparison, industry context, cash flow and related ratios keep a single number from becoming an unsupported verdict.
Formula choice begins with the user's decision. A short-term supplier may focus on current and quick ratios, a lender may combine liquidity with leverage, an owner may compare returns, and a manager may investigate inventory or receivables turnover. Each ratio preserves a numerator, denominator, period and unit.
Liquidity ratios generally compare balances at a reporting date, while turnover and return ratios compare a period flow with resources employed over that period. Average balances often provide a better denominator than a single closing balance, particularly when the business is growing or activity is seasonal. Calculation is only the first stage.
A higher current ratio could reflect more cash, slower receivables, excess inventory or reduced liabilities; those drivers have different implications. A faster inventory turnover might indicate efficient selling or stockouts that sacrifice revenue. Return on equity can rise through stronger profit or through heavier use of debt.
The analysis must reopen both parts of the fraction, compare prior periods and relevant peers, and seek confirming evidence from cash flow and operations. When data are limited, the response should state that limitation rather than convert numerical precision into false certainty. The final judgement explains the movement, its likely driver, the appropriate benchmark and the next evidence needed before action.
What this chapter covers
- 01
Current and quick ratios
- 02
Debt ratio
- 03
Return on assets
- 04
Return on equity
- 05
Inventory turnover
- 06
Receivables turnover
Worked example · free
Build a five-ratio dashboard
- +2Calculate current assets divided by current liabilities.
- +2Remove inventory to calculate the quick ratio.
- +2Divide total liabilities by total assets for leverage.
- +2Use average assets and average equity for the return measures.
- +2Interpret the results together and identify a comparison needed.
Key terms
- Liquidity
- The capacity to convert assets into cash and meet short-term obligations.
- Financial flexibility
- The ability to adapt financing and resources to change or opportunity.
- Profitability
- The relationship between earnings and the resources or owner funds used to generate them.
- Operating capability
- The ability to sustain operations, including efficient use of receivables and inventory.
Ratio Analysis for Business Decisions FAQ
Why can a high current ratio still be weak?
Current assets may be concentrated in slow inventory or overdue receivables. Reopen the numerator, compare the quick ratio and inspect operating cash before concluding that short-term coverage is strong.
Why does return on equity sometimes exceed return on assets?
Borrowing can allow owners to earn a return on a larger asset base than their equity alone financed. The spread can benefit owners, but the debt ratio and repayment capacity reveal the additional risk.
Is higher inventory turnover always better?
Higher turnover may reflect efficient sales and inventory control, but it can also mean stock levels are too low and customers face stockouts. Compare lost sales, replenishment time, margins and peer performance.
Exam move
Group formulas by the decision they answer rather than memorising an undifferentiated list. Predict the direction before calculating, use average balances for period-flow ratios when available and explain each movement through the underlying accounts. Always add a benchmark and a next investigative step to the final sentence. Build four formula cards headed liquidity, flexibility, profitability and operating capability.
On each card, write the user question before the formula. This ties current and quick ratios to short-term coverage, debt to financing risk, returns to resource use and turnover to operating efficiency. Rework the chapter dashboard after changing one account at a time. Predict whether the ratio rises or falls, then identify whether the apparent improvement has an alternative explanation.
A higher current ratio produced by slow inventory is different from one produced by cash. A higher return on equity produced by more debt carries a different risk from one produced by stronger profit. Use average assets, equity, inventory and receivables when the formula compares a period flow with a stock. If only closing data are available, state that limitation.
Compare every result with a prior period, plan, peer or industry context before using favourable language. Cross-check ratio families: pair return on equity with debt, current ratio with operating cash, and inventory turnover with stockout evidence. Finish each response with what the ratio suggests, what it cannot prove and which account, note or operating measure should be inspected next.
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