ANALYSIS BY RATIOS

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Financial Statement Analysis-FIN621

Lesson-33

RATIOS ANALYSIS

4. ANALYSIS BY RATIOS:

Financial Ratios are like financial temperatures, which give the state of the health of a business.

This analysis technique is most widely used. In these inter-linkages of Income Statement and

Balance Sheet items are established and inferences are drawn there from.

The analysis technique by Ratios would broadly consist of the following:-

Analysis by short-term creditors: Interest of short-term creditors is to watch the

ability of business to meet its debts as these become due; i.e. Short-term solvency.

They want to see whether business has the ability to meet its current liabilities out

of its current assets. I the entity can not maintain a short-term debt paying ability, it

will not be able to maintain a long-term debt-paying ability, nor will it be able to

satisfy its stockholders. Even a very profitable entity will find itself bankrupt if it

fails to meet its obligations to short-term creditors. The ability to pay current

obligations when due is also related to the cash-generating ability of the firm. While

analyzing the short-term debt-paying ability of the firm, we find a close relationship

between the current assets and the current liabilities. Generally the current liabilities

will be paid with cash generated from the current assets. Profitability of the firm

does not determine the short-term debt paying ability. Indicators of this ability are

the short-term solvency ratios, which are:-

Liquidity Ratios

Liquidity Ratios are used to measure a firm's ability to meet short-term obligations.

They compare short-term obligations to short-term (or current) resources available to meet these

obligations. From these ratios, much insight can be obtained into the present cash solvency of the

firm and the firm's ability to remain solvent in the event of adversity.

Current ratio = Current assets

Current liabilities

(Normal ratio for this is 2:1)

Current assets divided by current liabilities. It shows a firm's ability to cover its current

liabilities with its current assets. Higher the current Ratio, the greater the ability of the firm to pay its

bills; however, the ratio must be regarded as a crude measure because it does not take into account the

liquidity of the individual components of the current assets composed principally of cash and non-

overdue receivables is generally regarded as more liquid than a firm whose current assets consist

primarily of inventories. Consequently, we turn to a more critical, or sever, test of the firm's liquidity-

the acid test ratio

i.e. Current assets should be twice the current liabilities. It should however be noted

that too high ratio may indicate that capital is not being used productively and

efficiently. Such a situation calls for financial reorganization.

ii)

Quick ratio. This is also called acid-test ratio. In this, inventories and pre-paid

expenses are excluded from current assets. Only cash, marketable securities and

Receivables (called Quick Assets) are considered. For Quick Ratio, the normal ratio is

1:1 i.e. quick assets should be equal to current liabilities. It should be noted that current

ratio measures "general liquidity", whereas quick ratio measures "immediate liquidity".

Acid Test Ratio = Current assets- Inventories/ Current Liabilities

This ratio serves as a supplement to the current ratio in analyzing liquidity. This ratio is

the same as the current ratio except that it excludes inventories. Presumably the least

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Financial Statement Analysis-FIN621

liquid portion of current-assets-from the numerator. The ratio concentrates primarily on

the more liquid current assets, cash, marketable securities, and receivables, in relation to

current obligations. Thus, this ratio provides a more penetrating measure of liquidity

than does the current ratio.

Cash Ratio = Cash Equivalents + Marketable Securities/ Current Liabilities

The cash ratio indicates the immediate liquidity of the firm. A high cash ratio indicates that the

firm is not using its cash to its best advantages; cash should be put to work in the operations of

the company

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