This paper examines key financial ratios and stock valuation methods relevant to intermediate accounting. It covers the current ratio and quick ratio as measures of short-term liquidity, the days-sales-in-receivables ratio as an indicator of collection efficiency, and the gearing ratio as a measure of debt relative to capital. The paper also addresses the limitations of cross-industry ratio comparisons using grocery and construction company examples. Finally, it evaluates three stock valuation models — the One Period Valuation Model, the Derived Dividend Valuation Model, and the Earnings Growth Model — concluding that the Earnings Growth Model offers the most practical utility for contemporary managers.
When conducting business operations, entrepreneurs must demonstrate a wide range of capabilities in order to achieve their pre-established goals. They must be able to develop an extensive budgetary process, plan their resource consumption, and adequately allocate resources — whether human, financial, technological, or material. Another essential requirement is the ability to honor the company's current liabilities, or its short-term obligations. These are extremely varied and include elements such as utility bills, employee wages, and payments to suppliers.
There are two common ways in which economists measure a company's ability to pay its short-term debts: the current ratio and the quick ratio. The current ratio — also called the cash ratio, cash asset ratio, or liquidity ratio — is calculated by dividing current assets by current liabilities. The fact that it is measured through this division means that it strives to assess the organization's ability to pay its short-term obligations from its current assets. The current ratio is generally compared against 1; when it falls below 1, it indicates a reduced ability to pay debts and therefore represents an organizational weakness (Investopedia, 2009).
The quick ratio is similar to the current ratio in that it also measures a company's ability to pay its short-term debts, but it differs in that it considers only the company's most liquid assets rather than all current assets. It is calculated by first subtracting inventories from current assets, then dividing the result by current liabilities. Inventories are excluded because some companies find it extremely challenging to convert their assets into cash quickly; this feature makes the quick ratio more conservative and less commonly used than the current ratio. Like the current ratio, however, a higher value of the quick ratio indicates a stronger organizational position and greater short-term liquidity (Investopedia, 2009).
The days-sales-in-receivables ratio measures the average number of days it takes a business to collect its receivables from customers — in other words, how long it takes customers to pay their debts to the entity. Changes in this ratio do not necessarily produce strictly positive or strictly negative outcomes.
Given that throughout a single fiscal year Sony Corp.'s days-sales-in-receivables ratio increased from 36 to 43, it is necessary to understand this growth from several perspectives. First, the ratio should be assessed against the expected ratio that auditors estimated in advance. Second, it is important to analyze the current year's ratio in light of the previous year's figure. Finally, the company's ratio should be compared with the industry average (ABREMA).
If major discrepancies occur between the trend in Sony's days-sales-in-receivables ratio and the benchmarks against which it is compared, this generally signals an organizational weakness — indicating that the company is only limitedly capable of collecting receivables from its clients. Upon this realization, management at Sony would likely be advised to reassess the company's relationships with its customers. This would involve reviewing signed contracts to ensure that the stipulated terms are being respected. It might also be appropriate to modify contracts by introducing new clauses requiring clients to pay their debts to Sony within 30 business days.
The gearing ratio is a financial ratio that measures a company's capital against its debt — in other words, it identifies how much of a given company is funded by owners' capital and how much by debt (Investopedia, 2009). Regarding ABC Traders, the first gearing ratio indicates that for every one part of capital, two parts are debt. This elevated level of debt reveals organizational weakness, an increased dependence on borrowed funds, and a greater necessity to service that debt. The second gearing ratio shows that for every one part of capital, only 0.7 is represented by debt.
To make this information fully meaningful, it should be compared with industry averages and recent trends. Nevertheless, a general observation can be made: a decreasing level of debt is positive for the company and influences the decisions of various stakeholders. For instance, potential investors may not have been interested in ABC Traders at the time of the first measurement, when the company showed a pressing need to repay its debts. At the time of the second measurement, however, the proportion of debt in the owners' capital decreased significantly, meaning the company would be better positioned to pay dividends. Recognizing the prospect of greater financial returns, potential investors would find ABC Traders more attractive.
A second category of stakeholders affected by the change in the gearing ratio is ABC Traders' competitors. Observing the company's growing internal strength, competitors may feel compelled to improve their own operations. Reduced levels of debt make ABC Traders stronger and more competitive. To preserve their competitive position, other players in the industry will need to develop and implement more effective strategies.
As noted throughout the previous sections, the most effective way to conduct a relevant analysis of financial ratios is to compare them with industry averages. Companies within the same industry generally operate according to similar principles and therefore produce comparable ratios. Across different industries, however, such comparisons are less meaningful, because operations and outcomes are tied to fundamentally different factors.
"Why ratios differ across industries"
"Three models for valuing company stock"
Based on the evaluation of these three valuation methods, the Earnings Growth Model emerges as the easiest to implement and the most practically useful option for the contemporary manager. Its reliance on projected earnings and historical growth trends makes it both accessible and relevant for real-world decision-making.
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