Ratio analysis is probably most helpful when it is used in time series across several accounting periods. It shows how management responds to a variety of conditions. It is not terribly helpful to learn, for example, that the current net-profit margin is 4.6% or that the current ratio (short-term assets divided by short-term liabilities) is 2.5. It is much more significant to see how these measures move over time—to see, for example, that leverage as measured by the debt-to-net-worth ratio moved gradually upward over a period of years. Further analysis reveals that this upward trend in leverage was accompanied by increased inventory and receivable days. As it turns out, these were needed to accommodate a broader product line and some shift in distribution channels. Movement and trends in ratios tell us much more than just a single number can because we can infer from such trends much about management’s probable decision-making patterns.

Another aspect of ratio analysis is what it may tell us preliminarily about likely cash-flow implications; the ratios suggest a certain type of cash-flow impact. The cash-flow statement then tests and quantifies that suggestion more specifically. For example, close inspection of Jones Dynamite Co.’s financials would show
gradual deterioration of the current ratio from 2.2 to 1.8 over a three-year period and suggest declining liquidity—that is, a declining ability to pay current expenses from operating sources of cash. But when we look at the company’s cash-flow statement, it shows a significantly positive and increasing net cash-income value over the same three-year period.

The question, then, is which better measures liquidity—the acceptable and improving operating-cash flow from the cash-flow statement, or the significantly declining current ratio rooted in the static data from the balance sheet? The static measure might be more useful if the company were in big trouble and facing liquidation. In fact, though, most of the time we deal not with issues of immediate liquidation but with questions of ongoing operational cashflowability. Our focus is primarily the going concern and how to keep it going as it continues to generate most of its own fuel from internal operating sources. Recall that the inability to do just that is what drove the once great W.T. Grant Co. into bankruptcy.

Taken From : Cash Rules