Reflection Paper: Ratio Analysis and Analytical Techniques A. Ratio Analysis

The three main categories of ratios used in the financial analysis include solvency,
liquidity, and profitability. An enterprise often leverages a liquidity ratio to measure its capacity
to settle its current debt commitments without involving external capital. In business, liquidity is
an entity’s ability to convert its fixed assets into cash cheaply and quickly. The current ratio is
the most common type of liquidity ratio. The current ratio is used to estimate a enterprise’s
ability to offset or repay its current liabilities (those payable within a year) using its total current
assets like inventories, cash, and account receivable (Coulon, 2019). A higher current ratio
usually signifies a better liquidity position for the business. The current ratio is calculated by
subdividing a firm’s current assets by its current liabilities. Managers often use the current ratio
to evaluate a business’s aptitude to pay off its short-term (one-year) obligations using its current
assets, including prepaid liabilities, marketable securities, stock inventory, accounts receivables,
cash equivalents, cash, and other liquid assets.
On the other hand, solvency ratios are key financial measurements used by enterprises to
measure their capacity to meet their long-term debt obligations. Managers use solvency ratios to
determine whether their cash flow is enough to meet their long-term liabilities; they are typically
used to estimate a firm’s financial health or its ability to remain solvent for the long term. The
interest coverage ratio (calculated by subdividing earnings before interest and taxes or EBIT by
interest expenses) is a classic example of a solvency ratio that measures how many times a firm
can cover its existing interest repayments within the range of its available earnings. The interest
coverage ratio typically calculates the safety margin a firm has for paying interest for a given
period.

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Finally, profitability ratios are essentially used by managers or investors to measure an
enterprise’s ability to generate earnings (profits) relative to its shareholder’s equity, operating
costs, revenue, or balance sheet assets over a specified period. Profitability ratios are further
classified into two categories: return and margin ratios. Margin ratios denote a firm’s capacity to
convert sales into profits, while return ratios indicate how efficiently an enterprise generates a
return for investors. Return on equity (ROE) is one of the most important ratios used to measure
a firm’s ability to earn income or returns on its equity investments. ROE is calculated by diving a
firm’s net income by its shareholder equity.

B. Analytical Techniques

The net present value (NPV) is a financial measurement used by financial analysts to
analyze a project’s profitability. NPV is the cash flow’s current value at the project’s mandated
return rate compared to its initial investment. In other words, NPV is a technique for calculating
a project’s expenditure or ROI (Sekhar, 2018). By considering the profits or money a business or
project expects to get from an investment and relating the earnings to today’s dollars, one can
decide whether or not the project is worth investing in. The one advantage of using NPV is that it
allows companies to measure the money’s time value; this means that today’s dollar will be
worth more tomorrow as a result of its earning ability. Secondly, NPV can allow investors or
companies to determine whether a specific investment is loss-making or profit-making. On the
flip side, NPV has no standard guidelines for computing the required return rate. Another
downside is the inability to use NPV to compare investments or projects of varying sizes.
The internal rate of return (IRR) is a measurement used in estimating a project’s potential
profitability. It is a discount rate that renders all cash flow NPVs equal to zero when analyzing
the discounted cash flow. Although IRR uses the same formula as the net present value, it is not

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the project’s actual dollar value. This is one of its disadvantages. The other disadvantage is that it
ignores future costs and the project’s size. The advantage is that NPV considers the future timing
of cashflows, and the hurdle rate is not needed, reducing the risk of finding the wrong rate.
Finally, the payback method is an essential method used in assessing a project by
estimating the period in months or years it will take to recoup the initial investment (Sekhar,
2018). It is often calculated by dividing the amount of money invested and the estimated annual
net cash flow. The one advantage of this approach is that it is easier to understand and apply.
Secondly, the payback method can be used as a standalone tool to compare investments with no
explicit criteria needed for making decisions. The disadvantage of the payback method is that it
overlooks the cash flows beyond the estimated payback period; therefore, it disregards the
project’s long-term profitability. Also, it does not consider financing, value for money, and other
integral considerations like opportunity cost.

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References

Coulon, Y. (2019). Rational investing with ratios: Implementing ratios with enterprise value and
behavioral finance. Springer Nature.
Sekhar, C. (2018). Capital budgeting decision methods: Payback period, discounted payback
period, the average return of rate, net present value, profitability index, R, and modified
IRR. Independently Published.