How does ratio analysis assist firms from becoming insolvent?
Whilst ratio analysis will not necessarily help a firm increase it cash flows or profitability directly, such ratio analysis can be used as a litmus test to determine the current financial position of the company, areas of weakness, comparisons with benchmarks (similar firms, industry averages etc) and growth potential. The theory of ratio analysis is based around the cash-flow model where a firm is viewed as a reservoir of liquid assets which is supplied by inflows and drained by outflows. Thus, the solvency of a firm is defined in terms of profitability that the reservoir will be exhausted, at which point the firm will be unable to pay its obligations as they fall due. Four interdependent relationships are used in ratio analysis: 1. The existing liquid-asset reservoir 2. The net liquid-asset flow from current operations (cash flow) 3. The future “potential drain” from the firm’s debt obligations 4.
