Measuring Liquidity

Ratio Analysis
 Financial Analysis
• Assessment of the firm’s past, present and future financial
conditions

• Done to find firm’s financial strengths and weaknesses

• Primary Tools:
• Financial Statements
• Comparison of financial ratios to past, industry, sector and all
firms
Financial Statements
• Balance Sheet

• Income Statement

• Cash flow Statement

• Statement of Retained Earnings

 Factors affecting liquidity
1. Pattern and certainty of cash inflows

2. Certainty and prior knowledge of outflows

3. Availability and certainty of Inventory supplies

4. Easy and timely availability of short term borrowings

5. Other factors
Objectives of Ratio Analysis
• Standardize financial information for comparisons

• Evaluate current operations

• Compare performance with past performance

• Compare performance against other firms or

industry standards

• Study the efficiency of operations

• Study the risk of operations

 Measurement of liquidity
The liquidity level of the firm should be measured time to
time in order to:
i. Identify liquidity shortages or surpluses
ii. Compare liquidity position of the firm with other firms
in the same industry
Financial statements( B/S and P&L A/C) can be used to
measure the liquidity of a firm by calculating financial
ratios
 Classification of Ratios
Balance Sheet Ratio P&L Ratio or Income/Revenue Balance Sheet and Profit &
Statement Ratio Loss Ratio

Financial Ratio Operating Ratio Composite Ratio

Current Ratio Gross Profit Ratio Fixed Asset Turnover Ratio,

Quick Asset Ratio Operating Ratio Return on Total Resources Ratio,
Proprietary Ratio Expense Ratio Return on Own Funds Ratio,
Debt Equity Ratio Net profit Ratio Earning per Share Ratio, Debtors’
Stock Turnover Ratio Turnover Ratio,
Calculation and classification of ratios
• Operations and financial position of a firm can be described by studying its
profitability, long term and short term liquidity position and its operational
activities.
• Thus ratios can be classified as:
1. Liquidity ratios
2. Activity ratios
3. Leverage ratios
4. Profitability ratios
 Liquidity ratios
• Liquidity refers to maintenance of cash, bank balance and those assets which are
easily convertible into cash in order to meet the liabilities
• Liquidity ratios study the firm’s short term solvency and its ability to pay off
liabilities
• They may be termed as balance sheet ratios because the information required
for their calculation is available in the balance sheet only.
• Some of the common liquidity ratios are:
1. Current ratio
2. Quick ratio
3. Absolute liquidity ratio
4. Defensive interval ratio
5. Current assets to fixed assets ratio
 Activity ratios
• Also known as Performance ratios/Turnover ratios
• These ratios are used to assess the activity of a specific current
asset or current liability
• These ratios are a measure of movement and indicate how
frequently an account has moved/ turned over during a
period.
• Usually calculated with reference to sales or cost of goods sold
and are expressed in terms of rates or times
 Turnover Ratio
1.Inventory Turnover Ratio
2.Receivables or Debtors Turnover Ratio
3.Payables or Creditors Turnover Ratio
4.Fixed Assets Turnover Ratio
5.Cash Turnover Ratio
6.Working Capital Turnover Ratio
7.Capital Turnover Ratio
 Leverage(Solvency) Ratios
Also called Capital Structure Ratios
Debt Equity Ratio
Interest Coverage Ratio
Dividend Coverage Ratio
Proprietary Ratio
Fixed Assets Ratio
 Profitability Ratios
(i) Based on Sale : Profitability works as a measure
of efficiency and control, Higher the profits –
higher the efficiency, it calculated on the basis of
Sales or Capital employed.
(ii)Based on Investment : These ratios are
calculated to measure whether the business is
earning adequate return on capital invested or
not.
Profitability Ratios
• Gross Profit Ratio
• Net Profit Ratio
• Operating Ratio Based on Sale or Capital employed
• Expenses Ratio
Return on Capital Employed
Return on Total Assets
Return on Shareholder’s fund Based on Investment
Return on Equity Shareholder’s fund
Dividend Pay out Ratio (D/P Ratio)
Price Earning Ratio (P/E Ratio)
Current ratio= Current Assets/Current Liabilities
Also known as working capital ratio, Standard = 2:1
Quick Ratio/Acid Test Ratio/Liquid Ratio
Standard = 1:1
Absolute Liquidity Ratio/Super Quick
Ratio/Super Acid Test Ratio, Standard= .5:1
 Defensive Interval Ratio (DIR)
• Instead of looking at the firm’s liquid assets its better to measure whether the
liquid assets are large enough relative to firm’s regular cash outgoing. For this
DIR is used.

• It measures the capacity of the firm to meet its immediate cash requirements
without resorting to sales or other sources.

• Projected daily cash requirement= (COGS+ general expenses- Depreciation)/365

 Current asset to fixed asset ratio
Current asset to fixed asset= Current assets/ Fixed assets
•If the ratio is high, profitability will be low and the
firm will be termed as conservative firm
•If the ratio is low, liquidity will be low i.e the firm is
running the risk of working capital shortage and
thus will be termed as aggressive firm
 Particulars Amount
Cash 6,000
Debtors 74,000
Bills Receivables 10,000
Raw Materials 45,000
Work in Progress 55,000
Finished Goods 70,000
Prepaid Expenses 10,000
Land & Building 2,00,000
Patents 20,000
Tools 10,000
Goodwill 50,000
Bill Payable 20,000
Bank Overdraft 40,000
Creditors 30,000
Debentures 1,00,000
Q2. Z Ltd’s stock is Rs. 1,32,000/-
Liquid assets are Rs. 1,28,000/- and
quick ratio is 1.6, find out the
current ratio.
Q3. Current liabilities of a
company are Rs. 30,000/-.
Its current ratio is 3:1 and quick
ratio is 1.8:1. Calculate the value
of current assets, liquid assets
and stock.
 Turnover Ratio
• Stock Turnover Ratio/Inventory Turnover Ratio

= Cost of Goods Sold

Average Stock

Average Stock = Opening Stock + Closing Stock

2
•Debtors Turnover Ratio=
Net Credit Sales or Net Sales
Average Account Receivable

Average Account Receivable=

Opening Debtors + Opening B/R+ Closing B/R+ Closing Debtors
2
Average Collection Period = 365Days/52Weeks/12Months
Debtors Turnover Ratio
Leverage Ratios (Solvency Ratios)
Debt Equity Ratio = External Equity
Internal Equity
ExternalEquity=Debentures+LongTermLoan+Creditors
+B/P+OutstandingExpenses+Provision+ProposeDivided
Internal Equity = Equity Share+Preference Share+ Capital
Reserve+Revenue Reserve
 Fixed Assets Ratio
= LongTerm Fund
Fixed Assets
Debt to Total Fund Ratio

= Long Term Loans

Shareholder’s Funds + Long Term Loan
 Capital Gearing Ratio
= Equity Shareholder’s Fund
Fixed Cost Bearing Capital
Fixed Cost Bearing Capital = Preference Capital + Debentures + Mortgage Loan
Equity Shareholder’s Fund = Equity Share Capital + All Reserves & Surplus
 Interest Coverage Ratio

It is also known as Debt service Ratio or Fixed Charges Coverage Ratio

= EBIT (Earning Before Interest & Tax)

Total Interest
Dividend Coverage Ratio

= EAT (Earning After Tax)

Preference Dividend
From the following figures compute
Capital gearing ratio:
Equity Share Capital Rs.2,50,000/-
Preference Share Capital Rs. 1,00,000/-
Long-term loans Rs. 50,000/-

Ans. 1.67:1
Compute: Liquidity Ratio, Fixed Assets Ratio, Current
Ratio, Debt. Equity Ratio
Balance Sheet
as on 31.12.2008
Liabilities Rs. Assets Rs.
Share Capital 5,00,000 Fixed Capital 6,00,000

Fixed liabilities 2,50,000 Liquid Assets 3,00,000

Current Liabilities 2,50,000 Stock 1,00,000

10,00,000 10,00,000