This paper seeks to identify three financial ratios that might be especially important for a stock investor and a bank. This paper will also defend the selection by describing the position of each party such that it justified the selection. In other words, this will discuss what is unique about each party such that the financial analysis of each varies.
The three financial ratios that might be especially important to a stock investor include the return on investment, current ratio, and debt to equity ratio. In the case of a bank as a creditor, the most important would be the current ratio, followed by times interest earned and debt to equity ratio. A stock investor may be looking for a short-term investment or a long-term investment and in both cases, profitability will be important. However in the stock investor will be looking for a long-term capital gain, the equity debt becomes more important since the stability of the company would be more important than the current liquidity. If the short-term investment is the purpose, liquidity ratio or current ratio may be given more importance than the debt to equity ratio. Stability is measured by solvency ratios like the debt to equity ratio. Solvency like liquidity measures the ability of an enterprise to meet its debts obligations but the capacity for the first must be viewed long term (Brigham and Houston, 2002).
In the case of the bank as a creditor, liquidity is very important thus the need to look at the current ratio or quick asset ratio since the said ratios indicate the capacity to repay loans in the short term. Although profitability is important for a bank, liquidity takes more precedence than profitability since a profitable entity may be unable to pay his/her periodic amortization if the same is not liquid. In determining liquidity, there is a need to know the assets of the company about liabilities.
Company assets are either current or non-current. The company’s current assets are more liquid compared to its non-current assets. The former is used to pay maturing obligations while the latter is used to have long-term returns from the business. Current assets consist of cash, receivable, inventories, prepaid expenses, and other current assets. The other current assets other than cash are used by the company as part of its working capital.
When total current assets are reduced by current liabilities, working capital is produced which is used to maintain short-term requirements like salaries and accounts with suppliers as well as banks and current liabilities (Bernstein, 1993).
To conclude what causes the difference of the positions taken by the parties is the nature of their business. It could still be asserted that what would sustain a company to continue giving dividends to stockholders and debtor to be able to pay its debt amortization to creditor banks will still be dependent primarily on operations of the company-investee and creditor-bank which must produce profitability to sustain their good liquidity or current ratios and solvency or debt to equity ratios. However, for purpose of decision-making for either of the parties, the ratios are both subject to limitations such as their being historical. They are only suggestive that what happened in the past would greatly influence what will happen in the future.
References
Bernstein (1993). Financial Statement Analysis. Sydney: IRWIN.
Brigham and Houston (2002). Fundamentals of Financial Management. London:Thomson South-Western London, UK.