Chapter 3, Problem 1DQ

If we divide users of ratios into short-term lenders, long-term lenders, and stockholders,

which ratios would each group be most interested in, and for what reasons? (LO3-2)

Summary Introduction

Introduction: Ratios are used in our daily lives - from buying a car based on the average that it will provide to calculating the foul-shooting percentage in a baseball match. Ratios play a huge role in finance also. Financial ratios are used to calculate the operating performance of the company. Financial ratios can be divided into mainly four parts - profitability ratios, current ratios, asset utilization ratios, and debt utilization ratios.

Concept name: Shareholders, Short-term lenders, Long-term lenders which ratios they will be most interested in.

Answer to Problem 1DQ

Shareholders will be most interested in profitability and asset utilization ratios. Short-term lenders will be most interested in liquidity ratios and long-term lenders will be interested in debt-utilization ratio.

Explanation of Solution

The profitability ratios are used to calculate the capacity of the firm to generate returns on the total assets, sales, and capital invested. It basically gives an overview of the firm’s capability to employ its resources in an adequate manner. The shareholders are very keen to know the profitability ratio of the firm because it indicates the ability of the firm to generate returns. It can help shareholders have an overview of future growth. The liquidity ratios are used to calculate the firm’s ability to pay off short-term loans.

Short-term lenders are those that provide the firm with funds for a period of less than one year. These ratios will help short-term lenders analyze the firm’s liquidity and take a decision on whether to lend money or not. Debt-utilization ratios are used to calculate the firm’s debt. It helps long-term lenders analyze the firm’s ability to repay their long-term debt. This may help them invest accordingly in the firm.