Risk assessment plays an essential role in the global marketplace, particularly when it comes to deploying proper strategies to mitigate identified exposures. All organizations, including government agencies and charities, must set adequate plans to identify, monitor and remedy operating risks. Financial ratio analysis is part of the risk-assessment arsenal companies establish to weed exposures out of their operating activities.
Risk assessment helps a company understand its vulnerabilities and come up with a sound plan to permanently remedy -- or temporary mitigate -- them. An integral part of a risk management process, risk appraisal shows top leadership not only internal areas where the firm might lose money, but also external factors that could pose threats on their own or increase internal weaknesses. For example, if accounts receivable personnel are stealing company money and committing fraud, the organization may incur double losses -- first, because of reduced sales and cash balances, and second, due to adverse decisions that regulators might take.
Investors calculate financial ratios to evaluate companies operating in the same sector and determine a credible victor of the economic competition in that industry. They use the metrics to evaluate such factors as efficiency, profitability, solvency and liquidity. The idea is not to take corporate managers at their words, but compare and contrast various entities in related or different sectors and see whether top leadership is truly doing a good job managing company money and increasing market share.
Liquidity ratios deal with the way a company manages its cash, how it spends it and how it grows the firm's money pile. Examples include current ratio and quick ratio. Current ratio equals short-term assets minus short-term liabilities, such as accounts payable and salaries due. Quick ratio, a more stringent liquidity metric, equals cash plus accounts receivable divided by short-term debts. Profitability metrics gauge how much money an organization makes and how adeptly it does so. An example is net profit margin, which equals net income divided by sales. Efficiency ratios indicate how well businesses use operating resources to generate revenues. An example is inventory-turnover ratio, which equals material costs divided by inventory.
To appraise risk, investors and corporate management rely on various tools, including mainframe computers, financial ratios and accounting software. For example, financiers may review a company's liquidity and calculate its working capital to determine whether the business will have enough cash to repay its short-term lenders. Working capital equals short-assets, such as cash and accounts receivable, minus short-term debts.
- Idaho State University: Risk Assessment and Risk Mitigation
- Bank for International Settlements: Industry Views on Credit Risk Mitigation
- "Market Based Risk Mitigation: Risk Management vs. Risk Avoidance"; Shmuel Oren
- Federal Financial Institutions Examination Council: Risk Mitigation and Control Implementation
- Missouri Small Business and Technology Development Centers: Financial Ratios
- NetMBA: Financial Ratios
About the Limitations of Financial Analysis Ratios
Numbers don't lie. But, sometimes they bend the truth. Financial analysis ratios can provide valuable information, but they must be interpreted carefully.
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