Discuss the usefulness and limitations of financial ratios in Essay - 1

Discuss the usefulness and limitations of financial ratios in evaluating the performance and management of companies - Essay Example 300). The most common ratio is the current ratio/working capital ratio which represents the ratio of current assets to current assets. This ratio shows the company’s capability to meet its short term bills and expenses. Current ratio which is greater than one is more preferred since it means that the company has more current assets than current liabilities. A ratio which is less than one is unfavorable because it means that the company has more current liabilities than assets (Whittington 1980, p. 222). A high current ratio indicates a safety cushion and increases the flexibility since some of the stock items and receivables in arrears may not be easily be converted into cash. Entities can improve current ratio by the conversion of short term debts into long term debt, collecting promptly its receivables, buying inventory when only needed and necessary and paying down all debt. Current ratio is given by: This ratio is often termed as a more stringent liquidity test as it indicates whether a firm has adequate short-term assets to cover for current liabilities and this excludes selling inventory. A ratio of 1:1 shows that that an entity can pay its expenses without being forced to sell inventory (Barnes 1987, p.484). Working capital is a measure of cash flow and for an entity to be running well, this ratio must always be positive. This ratio measures the amount of that has been invested in resources subject to quick turn over. In most cases, lenders use this ratio to evaluate and ascertain the ability of the company at hard times (Whittington 1980, p. 219). In the financial year 2013, easy jet plc had the following liquidity ratios namely, current ratio of 0.89, quick ratio of 0.89 and a cash ratio of 0.75. All these ratios were positive thus favorable for the entity. One major limitation of the liquidity ratios is that they do not focus much on the