T.Y B.COM
SEMESTER - 5
FINANCIAL MANAGEMENT
(FM)
THEORY
UNIT 1
CHAPTER - 2
FINANCIAL STATEMENT ANALYSIS
LIQUIDITY RATIOS :
• "Liquidity" refers to the ability of the firm to meet its current liabilities.
• The liquidity ratios, therefore, are also called 'Short-term Solvency Ratios.'
• These ratios are used to assess the short-term financial position of the concern.
• They indicate the firm's ability to meet its current obligations out of current resources.
• In the words of Salomon J. Flink, "Liquidity is the ability of the firm to meet its current obligations as they fall due.
• In the words of Herbert B. Mayo, "Liquidity is the ease with which assets may be converted into cash without loss."
Short-term creditors of the firm are primarily interested in the liquidity ratios of the firm as they want to know how promptly or readily the term can meet its current liabilities. If the firm wants to take a short-term loan from the bank, the bankers also study the liquidity ratios of the firm in order to assess the margin between current assets and current liabilities.
Liquidity ratios include two ratios:
1. Current Ratio
2. Quick Ratio
1. Current Ratio :
The ratio is used to assess the firm's ability to meet its short-term liabilities on time. It is generally believed that 2:1 ratio shows a comfortable working capital position. However, this rule should not be taken as a hard and fast rule, because ratio that is satisfactory for one company may not be satisfactory for other. It means that current assets of a business should, at least be twice of its current liabilities. The reason of assuming 2: 1 as the ideal ratio is that the current assets include such assets as stock, Cash, debtors etc, from which full amount cannot be realized in case of need. Hence, even if half the amount is realized from the current assets on time, the firm can still meet its current liabilities in full.
Current Assets = Cash & Bank Balance + Stock + Debtors + Bills Receivable + Prepaid Expenses + Investments readily convertible into cash (marketable securities)
Current Liabilities = Creditors + Bills Payable + Bank Overdraft + outstanding exp + Provision for Taxation + Proposed Dividend.
Formula:
Current ratio = Current Assets / Current Liabilities
Significance:
It provides a measure of degree to which current assets cover current liabilities. The excess of current assets over current liabilities provides a measure of safety margin available against uncertainty in realization of current assets and flow of funds. The ratio should be reasonable. It should neither be very high or very low. Both the situations have their inherent disadvantages. A very high current ratio implies heavy investment in current assets which is not a good sign as it reflects underutilization or improper utilization of resources. A low ratio endangers the business and puts it at risk of facing a situation where it will not be able to pay its short-term debt on time. If this problem persists, it may affect firms credit worthiness adversely. Normally, it is safe to have this ratio within the range of 2:1.
2. Quick Ratio:
Quick or Acid Test indicates whether the firm is in a position to pay its current liabilities immediately.
An ideal acid test ratio is said to be 1:1. The idea is that for every rupee of current liabilities, there should at least be one rupee of liquid assets. This ratio is better test for short-term financial position of the company than the current ratio. Liquid assets are obtained by deducting stock-in-trade from current assets.
Stock is not treated as a liquid asset because it cannot be readily converted into cash.
Formula :
Liquid ratio = Current Assets - Stock In Trade / Current Liabilities
Significance: The ratio provides a measure of the capacity of the business to meet its short-term obligations without any flaw. Normally, it is advocated to be safe to have a ratio of 1:1 as unnecessarily low ratio will be very risky and a high ratio suggests unnecessarily deployment of resources in otherwise less profitable short-term investments.
EXAMPLES
Ex.1 Calculate Current Ratio and Liquid Ratio from the following information:
Inventories 50,000
Trade receivables 50,000
Advance tax 4,000
Cash and cash equivalents 30,000
Trade payables 1,00,000
Short-term borrowings (bank overdraft) 4,000
Solution:
Current Ratio = Current Assets / Current Liabilities
Current Assets = Inventories + Trade receivables + Advance tax + Cash and cash equivalents
= Rs. 50,000 + Rs. 50,000 + Rs. 4,000 + Rs. 30,000 = Rs. 1,34,000
Current Liabilities = Trade payables + Short-term borrowings
= Rs. 1,00,000 + Rs. 4,000 = Rs. 1,04,000
Current Ratio = Rs.1,34,000 / 1,04,000
= 1.29 : 1
Liquid Ratio = Current Assets – Stock / Current Liabilities
= 1,34,000 – 50,000 / 1,04,000 = 0.81 : 1
2. If current ratio is 3:1, working capital is Rs.15,00,000. Calculate the current assets.
3. P Ltd. has current liabilities Rs. 30,000. Current ratio 3:1 and quick ratio 1:1. How much is stock-in-trade?
4. Balance sheet of KABEL Ltd. Indicates that its current ratio is Rs.2.5:1 and its net working capital is Rs.30,00,000. Find out the amount of current assets. (50,00,000)
5. Following trend ratios have been extracted from the audited records at a large sized industrial company:
|
Particulars |
Current ratio |
Acid test ratio |
|
2010 |
1.80 : 1.00 |
1.70 : 1.00 |
|
2011 |
1.90 : 1.00 |
1.20 : 1.00 |
|
2012 |
2.10 : 1.00 |
0.90 : 1.00 |
|
2013 |
2.20 : 1.00 |
0.70 : 1.00 |
|
2014 |
2.90 : 1.00 |
0.60 : 1.00 |
Interpret the trend of these interrelated ratios for judging the short-term liquidity and solvency of the company.
Answer :
From the data available it is observed that the current ratio has increased from 1.80 :1.00 to 2.90 : 1.00 in a span of 5 years. The ideal ratio is 2.00:1.00. This improvement in current ratio must reflect in the improvement of short-term solvency. But when we analyze the acid test ratio, it is fallen down from 1.70 : 1.00 in 2010 to 0.60 : 1.00 in 2014. This means that most of the current assets are blocked up in stocks over a period of time. The ideal standard acid test ratio is 1.00 : 1.00. It means that the company is not in a position to meet its immediate current liabilities; it may lead to technical insolvency. Hence steps should be taken to reduce the investment in inventory and see that the acid test ratio is above the level 1.00 : 1.00.
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