Financial Management - Term Paper Example

income statement (Profit & Loss Account), statement of financial position (Balance Sheet) and a statement of changes in financial position (Cash Flow Statement), it is called Accounting Ratio. Accounting Ratios are very powerful analytical tools for measuring performance of a business enterprise. The basic objectives of Ratio Analysis are: To provide a deeper analysis of the liquidity, solvency, profitability and activity levels of a business enterprise. To know about the potential areas that could be improved with more effort in the desired direction.

To provide information for making inter-firm comparison and intra-firm comparison by comparing firm’s performance with best in the industry figures. The advantages of using Ratio Analysis are: These ratios help the management to analyze past performance and also to make future projections. Interested stakeholders as shareholders, investors, creditors and governments and independent analysts can evaluate certain aspects of a business with the help of ratio Analysis. Accounting ratios provide an easy way to compare current performance with previous periods.

These Ratios correctly elucidate the strengths and weaknesses of a firm’s operations and provide a clear insight about the financial health of a firm. Current Ratio The purpose of this ratio is to shed further light on the short-term solvency of the company and, more specifically, on its ability to pay the debts as they fall due, by calculating the relation between current assets and current liabilities. A widely used rule of the thumb is that a current ratio of 2:1 is an ‘ideal’ ratio.

However, such a generalization is not always true. The standard ratio will vary from industry to industry and within the same industry from season to season, depending upon the rate at which current assets are converted into cash and how quickly current liabilities must be paid. The ratio cannot be accepted as adequate without considering the composition of its current assets and their liquidity. A high current ratio will not be a measure of solvency of business if the current assets are made up mainly of obsolete stock or debtors outstanding for a long time.

The current ratio of PepsiCo is 1.44 (PepsiCo Inc., 2010) while that of Coca Cola is 1.13 (Coca-Cola Enterprises Inc., 2010). Though the current ratios of both the companies fall short of the ‘ideal’ standard but considering the fact that both are multinational beverages giants in their own right it must be said that PepsiCo scores over Coca-Cola in this regard as it is in a better position to honor its current liabilities as and when they fall due. Profitability Indicator Ratios Profitability ratios measure a concern’s degree of success in earning a return on sales or on investment.

The rate of return on capital employed, often described as the primary ratio, relates the income earned from the company’s activities to the resources employed by the company. The ratio indicates the efficiency with which the capital employed in the business is being utilized, and by comparison with other businesses it may provide a means of evaluating whether the management has the ability of to earn a reasonable income for the company with the resources at their disposal. There are a number of ways of computing rate of return on capital employed depending upon the definition of ‘capital employed’.

The term ‘capital employed’ is used, in accountancy to signify three different financial totals: (i)