A NOTE ON FINANCIAL RATIO ANALYSIS

LIQUIDITY RATIOS

Liquidity refers to the ability of a firm to meet its short-term (usually up to 1 year) obligations. The ratios which indicate the liquidity of a company are Current ratio, Quick/Acid-Test ratio, and Cash ratio. These ratios are discussed below.

CURRENT RATIO

Current ratio (CR) is the ratio of total current assets (CA) to total current liabilities (CL). Current assets include cash and bank balances; inventory of raw materials, semi-finished and finished goods; marketable securities; debtors (net of provision for bad and doubtful debts); bills receivable; and prepaid expenses. Current liabilities consist of trade creditors, bills payable, bank credit, provision for taxation, dividends payable and outstanding expenses. This ratio measures the liquidity of the current assets and the ability of a company to meet its short-term debt obligation.

Current Ratio = Current Assets / Current Liabilities

CR measures the ability of the company to meet its CL, i.e., CA gets converted into cash in the operating cycle of the firm and provides the funds needed to pay for CL. The higher the current ratio, the greater the short-term solvency. While interpreting the current ratio, the composition of current assets must not be overlooked. A firm with a high proportion of current assets in the form of cash and debtors is more liquid than one with a high proportion of current assets in the form of inventories, even though both the firms have the same current ratio. Internationally, a current ratio of 2:1 is considered satisfactory.

QUICK OR ACID-TEST RATIO

Quick Ratio (QR) is the ratio between quick current assets (QA) and CL. QA refers to those current assets that can be converted into cash immediately without any value dilution. QA includes cash and bank balances, short-term marketable securities, and sundry debtors. Inventory and prepaid expenses are excluded since these cannot be turned into cash as and when required.

Quick Ratio = Quick Assets / Current Liabilities

QR indicates the extent to which a company can pay its current liabilities without relying on the sale of inventory. This is a fairly stringent measure of liquidity because it is based on those current assets which are highly liquid. Inventories are excluded from the numerator of this ratio because they are deemed the least liquid component of current assets. Generally, a quick ratio of 1:1 is considered good. One drawback of the quick ratio is that it ignores the timing of receipts and payments.

CASH RATIO

Since cash and bank balances and short term marketable securities are the most liquid assets of a firm, financial analysts look at the cash ratio. The cash ratio is computed as follows:

Cash Ratio = (Cash and Bank Balances + Current Investments) / Current Liabilities

The cash ratio is the most stringent ratio for measuring liquidity.

OPERATIONAL/TURNOVER RATIOS

LEVERAGE/CAPITAL STRUCTURE RATIO

PROFITABILITY RATIOS

VALUATION RATIOS

CALCULATING FINANCIAL RATIOS OF HLL

COMMON SIZE INCOME STATEMENT OF HLL