When deciding on whether or not to invest in or work with another company, an evaluation of the financial statements is very important. Financial ratios based on the financial statements are used to evaluate the health of an organization. The ratios can be used to compare the performance from one reporting period to the next, or can be used to compare against other companies in the same industry. The steps to analyzing a company involve determining the ratios to use, determining the weighting factors for each of the ratios, and asking the right questions to determine the relative importance of the ratios.
Determining Weighting Factors
In evaluating the financial health of an organization, different financial measures can be used. However, not all these financial measures will have the same importance to the evaluator. Weighting of financial ratios is done to state the relative importance of each of the types of financial ratios (U.S. Department of Education, 1997). In the simulation, there were four different categories of financial measures that were evaluated: (1) turnover, (2) liquidity, (3) capital structure, and (4) profitability. Determining how much weight to provide to each measure requires that the analyst review the company's expectations in order to ask the right questions to determine what information will be most valuable to the company.
Turnover Ratios
Turnover ratios, also known as efficiency or activity ratios, measure how effectively a firm is using resources. In general, for all these ratios, a higher ratio is better for the company (NetMBA, 2005). The simulation covered the inventory turnover ratio, the receivables turnover ratio, and the asset turnover ratio.
Inventory Turnover
This ratio is calculated by dividing cost o ...