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Use and Abuse of Ratio Analysis
Financial ratio analysis is intended to measure specific financial performance attributes of a company. A credit decision-maker will make better informed decisions by using financial ratios in their customer analysis. Ratio analysis is used to arrive at better-informed credit decisions, but it is sometimes used improperly. This typically occurs when the ratios being calculated are not necessarily indicative of what they are supposed to measure. For example:
The current ratio is used to measure a company's liquidity (the availability of cash or the ability to obtain cash quickly in order to pay debts as they come due). A 1 to 1 current ratio means the company has $1.00 in current assets for each $1.00 in current liabilities. But the current ratio is simply too crude a tool to measure a customer's ability to pay its creditors. Why? Because the current ratio ignores timing of cash receipts and cash payments. Here is an example illustrating this point:
Assume we have a $1,000 order pending for a customer that has $10,000 in current assets and $20,000 in current liabilities. Conventional wisdom says this customer probably has serious cash-flow problems with a current ratio of .50 to 1. A low current ratio indicates a potential problem, but the creditor reviewing the customer's financial statements has no way of knowing:
- When the accounts payable balance is due or
- How soon the current assets will be converted into cash.
In this scenario, it is possible the $20,000 debt is due 360 days from the now, and that the $10,000 will be collected tomorrow. If this is true, this customer would probably have no trouble paying the $1,000 invoice if it were shipped on net 30 day terms. In this situation, the current ratio is not a true measure of the customer's available cash. Hopefully, this example illustrates just one of the potential problems with financial ratio analysis.
© 2011. Michael C. Dennis. All Rights Reserved.