Question

We have covered several ratios in this unit that users of financial statements can work with to evaluate a company’s performance.

Service organizations have different business models than manufacturing organizations. Explain which financial ratios would be applicable to a service company and which would not. State the reasons for your assertions.

Answer 1

There a typically 4 broad categories of ratios:

1. Liquidity Ratios:

1. Current Ratio
2. Liquid Ratio
3. Cash Ratio
4. Operating Cash flow Ratio

These all are applicable on a service sector firm as these are associated with current assets and liabilities. A service sector firm may or may not have fixed assets but they do have current assets & liabilities which are required to find out these ratios.

2. Leverage Ratios:

1. Debt Ratio
2. Debt-Equity Ratio
3. Coverage Ratios

These may or may not be applicable on a service provider. This reason is:

1. the service firm may not have non-current assets or liabilities
2. The firm may not have borrowed from external sources
3. Due to non-borrowed funds, no interest obligation stands.

3. Efficiency Ratios:

1. Inventory Turnover

This ratio can’t be enforced on a service firm as they usually don’t have any inventory. Service is an intangible factor. Inventory of this firm may or may not exist.

4. Market Value Ratios:

1. Dividend Yield
2. EPS
3. DPS
4. Book value per share
5. Return on Equity

Those service firms who don’t have equity-oriented funding will not be using these ratios.