The Ratio Method

A ratio is a quotient between magnitudes that have a certain relation and that are why they are compared.  Ratios are not study alone but are compared with other ratios that could be:

Ratios of the same company for studying its evolution through time

General type ideal ratios to prove in which situation is the company in relation with what are considered as ideal.

Sector type ideal ratios to prove if the company obtains the profitability that it supposes in function with the economic sector in which it operates.

There are many types of ratios. The following are the main ratios for liquidity, solvency or debt, of profitability and of investment.

Liquidity Ratios: The objective of these types of ratios is to analyze the liquidity situation of a company, that is, the possibility of confronting its payments. The most used ratios of liquidity are:

Liquidity Ratios: is the relation between current assets and current liabilities, where the current assets are those whose terms of realization are inferior to a year, and where the current liabilities are those whose terms of requirements are inferior to a year.

With this ratio you value the liquidity of a company and you can appreciate its short-term solvency. It must be superior to one.

If it where inferior to a unit, it would indicate that the company wouldn’t be able to confront its short-term debts and that there is a danger of suspending those payments. If it is very superior to a unit it can mean the existence of lazy current assets, which consequently would mean the loss of profitability.

Treasury ratios: In the relation between current assets (without counting the inventories and the current liabilities. Orr the equivalent, the realizable plus the available, divided by the short-term demands.

For they’re not to have any problems of liquidity, this ratio must be approximately equal to the unit. If its inferior to one, it indicates that the company may suspend the payments for having an excess of inventory and for having a lack of realizable and of available.

If the ratio is excessively more than the unit, it indicates the possibility that the company has an excess of liquid assets and that they are loosing profitability.

Immediate or available treasury ratios: is the relation between the available assets and the current liabilities of short term equitable. This ratio makes reference to the capacity of the company to confront with cash its debts.

An excess of treasury may mean that the company doesn’t use correctly its financial resources (immobilize treasury), for which they run the risk of seeing its profitability wear off.

It can also mean, that the company doesn’t show an adequate aggressiveness on the market.

On the other hand, if the value of the ratio is low, they might have problems to attend its payments.

It is difficult to estimate an ideal value for this ratio; due that it is very fluctuating along the year, but the critic value usually considered is of about 0.2.