Financial ratio analysis is conducted by four groups of analysts: managers, equity investors, long-term creditors, and short-term creditors. What is the primary emphasis of each of these groups in evaluating ratios?

Question

Ace Industries has current assets equal to $3 million. The company’s current ratio is 1.5, and its quick ratio is 1.0. What is the firm’s level of current liabilities? What is the firm’s level of inventories?

Answer 1

Primary Emphasis of Each Group in Financial Ratio Analysis

1. Managers:

   • Primary Emphasis: Operational efficiency and performance metrics. Managers focus on how well the company is performing against its own benchmarks and strategies. They analyze ratios to identify strengths and weaknesses, areas for improvement, and to make informed decisions regarding operational adjustments, resource allocation, and strategic initiatives.

2. Equity Investors:

   • Primary Emphasis: Profitability and growth potential. Equity investors evaluate financial ratios to assess the company's ability to generate returns on their investments. They often focus on ratios such as earnings per share (EPS), price-to-earnings (P/E) ratios, return on equity (ROE), and profit margins to determine the company’s valuation and future growth prospects.

3. Long-term Creditors:

   • Primary Emphasis: Solvency and financial stability. Long-term creditors (like bondholders) are particularly interested in a company’s long-term ability to meet its obligations. They analyze ratios such as debt-to-equity, interest coverage ratio, and overall leverage to ensure that the company has the capacity to repay long-term debt.

4. Short-term Creditors:

   • Primary Emphasis: Liquidity. Short-term creditors (like suppliers and banks extending short-term credit) focus on a company's ability to meet its short-term liabilities. They evaluate ratios such as the current ratio, quick ratio, and cash flow to ensure that the company has sufficient liquidity to cover its upcoming obligations.

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Calculation of Current Liabilities and Inventories for Ace Industries

Given:

• Current Assets (CA) = $3,000,000
• Current Ratio (CR) = 1.5
• Quick Ratio (QR) = 1.0

1. Calculate Current Liabilities (CL):

The current ratio is defined as:

\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \]

Using the values we have:

\[ 1.5 = \frac{3,000,000}{CL} \]

Rearranging to find \(CL\):

\[ CL = \frac{3,000,000}{1.5} = 2,000,000 \]

So, the firm's level of current liabilities is $2,000,000.

2. Calculate Inventories (I):

The quick ratio is defined as:

\[ \text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventories}}{\text{Current Liabilities}} \]

Given that the quick ratio is 1.0:

\[ 1.0 = \frac{3,000,000 - I}{2,000,000} \]

Rearranging gives:

\[ 3,000,000 - I = 2,000,000 \]

Solving for \(I\):

\[ I = 3,000,000 - 2,000,000 = 1,000,000 \]

So, the firm’s level of inventories is $1,000,000.

Summary

• Current Liabilities: $2,000,000
• Inventories: $1,000,000