Current Ratio: current assets / current liabilities

• Organizations ability to meet its short term obligations

• Unit of measure is times,
• ideally it should be 2:1
• The higher the ratio the better as it indicates liquidity
• It also means inefficient use of cash and other current assets
• It results in increase in cash and an increase in long term debt
• Companies with an aggressive financing policy will have lower current ratios, an
d conservative financing policies result in higher current ratios.
• Generally, a firm’s current ratio should be proportional to its operating cycle. T
his means that shorter the operating cycle, the lower the current ratio can be.
This is because the operating cycle will generate new current assets more quickl
y than a company with a long operating cycle. These new current assets can be us
ed to settle the liabilities.
Quick Ratio: quick assets / quick liabilities (ACID TEST RATIO)
Quick Assets: CA- (stock + prepaid exp)
Quick Liabilities: CL- Bank OD
• Concerned with short term liquidity,
• ideally it should be 1:1
• More appropriate measure since liquid assets represent the source of funds from
which current liabilities are likely to be met
DEBT EQUITY RATIO
• Establishes the relationship between external and internal long term financing.
• Compares total liabilities to total shareholders equity
• The main advantage of debt is that it provides an opportunity for greater return
s to shareholders
• ideally it should be 2:1
• Equity share capital + Preference share capital + Reserves & Surplus - Fictitiou
s assets
• Long term loan +Short term loan:
• • if it is not payable within a year even otherwise when the question is silent
• • If it is not protected by securities
• In debt equity ratio higher the debt fund used in capital structure, greater is
the risk.
• • In debt equity ratio, operates favorable when if rate of interest is lower than
the return on capital employed.
• If debt equity ratio is comparatively higher then the financial strength is bett
er.
INTEREST COVERAGE RATIO= EBIT/INTEREST (times interest earned ratio)
• Pbit/fixed interest charges
• Measures the safety available to Bank for recovery of interest
• ideally it should be 2:1
• if it is below 1.5 the risk of default is high
• higher the better
P/E RATIO (PRICE EARNING RATIO)
• market price per share/ earnings per share
• higher the better
• indication of what shareholders are paying for continuing earnings per share
• indications of what the market considers to the firms future earning power
• A stock with a high P/E ratio suggests that investors are expecting higher earni
ngs growth in the future compared to the overall market, as investors are paying
more for today s earnings in anticipation of future earnings growth
• Suppose the PEM is 12. Typically, this means that if all earnings are distribute
d as dividends then it would take the investor 12 long years before he recovers
his initial investment. If that be so, why do investors invest in companies wit
h high PEM? Reason: Investors expect the company’s earnings to grow. The PEM can h
ence be looked upon as an investor’s confidence in the growth prospects of the com
pany.
CA- TURNOVER = SALES/CA
EPS
Net profit after interest and tax/ Number of equity shares
• This is the ratio of profit after tax and preference dividends to number of equi
ty shares outstanding.
• This measures the amount of money available per share to equity shareholders.
• In the case of earnings per share, a distinction is made between basic and dilut
ed income per share. In the case of the latter, companies with outstanding warra
nts, stock options, and convertible preferred shares and bonds would report dilu
ted earnings per share in addition to their basic earnings per share.
• The concept behind this treatment is that if converted to common shares, all the
se convertible securities would increase a company s shares outstanding. While i
t is unlikely for any or all of these items to be exchanged for common stock in
their entirety at the same time, conservative accounting conventions dictate tha
t this potential dilution (an increase in a company s shares outstanding) be rep
orted. Therefore, earnings per share come in two varieties - basic and diluted (
also referred to as fully diluted). An investor should carefully consider the di
luted share amount if it differs significantly from the basic share amount. A co
mpany s share price could suffer if a large number of the option holders of its
convertible securities decide to switch to stock.