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Master of Commerce

ADVANCED ACCOUNTANCY

Subject: Advance Financial Management

Semester III

(2016-2017)

Submitted

In partial Fulfilment of the requirement for the

Award of Degree of Master of Commerce in Advanced Accountancy

Submitted By,

Name: Pooja R. Yadav

Roll No. 53

Under the Guidance of,

Prof. DHIREN KANABAR

Name of the Project: Financial Position Ratios

GURU NANAK KHALSA COLLEGE OF ARTS, SCIENCE


AND COMMERCE, MATUNGA, MUMBAI- 400019
GURU NANAK KHALSA COLLEGE OF ARTS, SCIENCE
AND COMMERCE, MATUNGA, MUMBAI- 400019.

CERTIFICATE
This is to certify that Miss Pooja R. Yadav of M.Com- II
ADVANCED ACCOUNTING Semester III (2016-2017) has
successfully completed the project on Financial Position Ratios under
the guidance of Prof. Dhiren kanabar

Course Co-ordinator Principal

Prof. Allan DSouza Dr. Kiran Mangoankar

Project Guide/Internal Examiner

Prof. DHIREN KANABAR.

External Examiner

Prof. N.N. JANI.


DECLARTION

I, Miss Pooja R. Yadav student of M.Com ADVANCED


ACCOUNTING Semester - III (2016-2017) hereby declares that I have
completed the Project on Financial Position Ratios. The information
submitted is true and original to the best of my knowledge.

Signature of student

Name: Miss Pooja R. Yadav


ACKNOWLEDGEMENT

The college, the faculty, the classmates & the atmosphere, in the
college were all the favourable contributory factors right from the point
when the topic was to be selected till the final copy was prepared. It
was a very enriching experience throughout the contribution from the
following individuals in the form in which it appears today. I feel
privileged to take this opportunity to put on record my gratitude
towards them. Prof. DHIREN KANABAR. Made sure that the
resource was made available in time & also for immediate advice &
guidance throughout making this project. Prof. Allan DSouza, the
Co-ordinator for M.Com of our college Guru Nanak Khalsa College
has always been inspiring & driving force. We are thankful to everyone
associated with administration part of ADVANCED
ACCOUNTANCY section has been very helpful in making the
infrastructure available for data entry.
INDEX
Meaning
TYPES OF FINANCIAL RATIOS
SHORT TERM LIQUIDITY RATIOS:

i) Current Ratio:
ii) Quick Ratio:
Advantages and Disadvantages of Current Ratio:
QUICK RATIO
Advantages and Disadvantages of Acid Test Ratio/ Quick Ratio
Capital Gearing

Fixed Asset to Capital ratio:

Formula:

Meaning: Interest Coverage Ratio


COMPUTATION OF B/S RATIOS AT A GLANCE
REVENUE STATEMENT RATIOS
Illustration
BIBLIOGRAPHY
Meaning
A financial ratio or accounting ratio is a relative magnitude of two selected numerical values
taken from an enterprise's financial statements. Often used in accounting, there are many
standard ratios used to try to evaluate the overall financial condition of a corporation or other
organization.
Financial ratio
A financial ratio or accounting ratio is a relative magnitude of two selected numerical values
taken from an enterprise's financial statements. Often used in accounting, there are many
standard ratios used to try to evaluate the overall financial condition of a corporation or other
organization. Financial ratios may be used by managers within a firm, by current and potential
shareholders (owners) of a firm, and by a firms creditors. Financial analysts use financial ratios
to compare the strengths and weaknesses in various companies.[1] If shares in a company are
traded in a financial market, the market price of the shares is used in certain financial ratios.

Ratios can be expressed as a decimal value, such as 0.10, or given as an equivalent percent value,
such as 10%. Some ratios are usually quoted as percentages, especially ratios that are usually or
always less than 1, such as earnings yield, while others are usually quoted as decimal numbers,
especially ratios that are usually more than 1, such as P/E ratio; these latter are also called
multiples. Given any ratio, one can take its reciprocal; if the ratio was above 1, the reciprocal
will be below 1, and conversely. The reciprocal expresses the same information, but may be
more understandable: for instance, the earnings yield can be compared with bond yields, while
the P/E ratio cannot be: for example, a P/E ratio of 20 corresponds to an earnings yield of 5%.

Introduction to Financial Ratios

When computing financial ratios and when doing other financial statement analysis always keep
in mind that the financial statements reflect the accounting principles. This means assets are
generally not reported at their current value. It is also likely that many brand names and unique
product lines will not be included among the assets reported on the balance sheet, even though
they may be the most valuable of all the items owned by a company.
These examples are signals that financial ratios and financial statement analysis have limitations.
It is also important to realize that an impressive financial ratio in one industry might be viewed
as less than impressive in a different industry.

Our explanation of financial ratios and financial statement analysis is organized as follows:

Balance Sheet
o General discussion
o Common-size balance sheet
o Financial ratios based on the balance sheet
Income Statement
o General discussion
o Common-size income statement
o Financial ratios based on the income statement
Statement of Cash Flows
The following financial ratios are derived from common income statements and used to
compare different companies within the same industry. There are other ratios that are gleaned
from an income statement, though the ones below represent some of the most common.

Gross Margin

Gross margin is calculated by dividing gross profit by net sales. This ratio shows the
percentage of sales revenue available for profit or reinvestment after the cost of goods sold is
deducted.

Profit Margin

Calculated by dividing net income after tax by net sales, a profit margin ratio shows the profit
per sale after all other expenses are deducted.

Operating Margin

Operating margin equals operating income divided by net sales. This is used to show how
much revenue is left over after paying variable costs such as wages and raw materials.

Earnings Per Share

The result of net income less dividends on preferred stock, which is then divided by
averageoutstanding shares, earnings per share is a crucial determinant of the price of a
company's shares because of its use in calculating price-to-earnings.

Price-earnings Ratio

The price-earnings, or P/E ratio, is calculated by taking market value per share divided by
earnings per share. This is one of the most widely used stock valuations and generally shows
how much investors pay per dollar of earnings.

Times Interest Earned

Divide earnings before interest and taxes, or EBIT, by total annual interest expenses and get
thetimes interest earned, or TIE, ratio. TIE is an indication of a company's ability to meet
debt payments.
Return on Stockholders' Equity

Return on equity is another critical valuation for shareholders and potential investors and can
be calculated by dividing net income after taxes by weighted average equity, though there are
several other variations. This indicates the percentage of profit after taxes that the corporation
earned.

General Discussion of Income Statement

The income statement has some limitations since it reflects accounting principles. For
example, a company's depreciation expense is based on the cost of the assets it has acquired
and is using in its business. The resulting depreciation expense may not be a good indicator
of the economic value of the asset being used up. To illustrate this point let's assume that a
company's buildings and equipment have been fully depreciated and therefore there will be
no depreciation expense for those buildings and equipment on its income statement. Is zero
expense a good indicator of the cost of using those buildings and equipment? Compare that
situation to a company with new buildings and equipment where there will be large amounts
of depreciation expense.

The remainder of our explanation of financial ratios and financial statement analysis will use
information from the following income statement:
Common-Size Income Statement

Financial statement analysis includes a technique known as vertical analysis. Vertical analysis
results in common-size financial statements. A common-size income statement presents all of
the income statement amounts as a percentage of net sales. Below is Example Corporation's
common-size income statement after each item from the income statement above was divided
by the net sales of $500,000:

The percentages shown for Example Corporation can be compared to other companies
and to the industry averages. Industry averages can be obtained from trade associations,
bankers, and library reference desks. If a company competes with a company whose stock
is publicly traded, another source of information is that company's "Management's
Discussion and Analysis of Financial Condition and Results of Operations" contained in
its annual report to the Securities and Exchange Commission (SEC). This annual report is
the SEC Form 10-K.

TYPES OF FINANCIAL RATIOS

Ratio Analysis is a form of Financial Statement Analysis that is used to obtain a quick indication
of a firm's financial performance in several key areas. Financial ratios are categorized according
to the financial aspect of the business which the ratio measures.
Financial ratios allow for comparisons
between companies
between industries
between different time periods for one company
between a single company and its industry average

Ratios generally hold no meaning unless they are benchmarked against something else, like past
performance or another company. Thus, the ratios of firms in different industries, which face
different risks, capital requirements, and competition, are usually hard to compare.

In the analysis of financial statements it is better to have a complete understanding of the


different types of ratios, their calculation, and interpretation. Financial ratios can be classified
into five types as follows.

1. Liquidity ratios

2. Asset Management ratios

3. Leverage ratios

4. Profitability ratios

5. Valuation ratios

1. Liquidity ratios

Liquidity ratios asses the firm`s ability to meet its short- term obligations using short-term assets.
The short-term obligations are the ones recorded under current liabilities that come due within
one financial year. Short-term assets are the current assets. There are three (03) important
liquidity ratios.
1. Current Ratio:

The current ratio (CR) is equal to total current assets divided by total current liabilities. This
indicates the extent to which current liabilities can be paid off through current assets.

2. Quick asset Ratio:

One Key problem with the current ratio is that it assumes that all current assets can be converted
in to cash in order to meet short-term obligations. We know this assumption is highly untrue.
Firms carry current assets, such as inventory and pre-paid expenses which cannot be converted
into cash quickly. To correct this problem, the quick asset ratio (QAR) removes from current
assets less liquid current assets, such as inventory and pre-paid expenses, which cannot be
converted into cash quickly. The quick ratio, also called the acid test ratio, is equal to liquid
current assets, divided by current liabilities. It indicates the extent to which current liabilities can
be paid off through liquid current assets such as cash, marketable securities, and accounts
receivables.

Quick asset Ratio = Current Assets Inventory


Current Liabilities

3. Cash Ratio:

The cash ratio goes a step further and examines the ability of the firm to settle short-term
liabilities using only cash and cash equivalents such as marketable securities. In other words, the
cash ratio indicates the extent to which current liabilities can be paid through very liquid assets.

Cash Ratio = Cash + Marketable Securities


Current Liabilities

2. Asset Management ratios

Asset management ratios also known as efficiency ratios indicate the efficiency of the use of
assets in generating sales. There are five (05) more important efficiency ratios: average
collection period, inventory turnover, cash conversion cycle, fixed assets turnover and total
assets turnover.

1. Average Collection Period:

The average collection period (ACP), also known as days sales outstanding (DSO), indicates the
average length of time the firm must wait after making a credit sale before it collects cash. In
other words, it shows the average number of days accounts receivables remain outstanding. The
ACP is calculated as follows:

Average Collection Period = Receivables


Annual Credit Sale/365
This is an important ratio used to evaluate the credit policy of the firm in relation to the industry
norms. A higher ACP indicates a liberal policy in that the firm gives more times to debtors for
making payments. A lower ACP indicates astringent policy in that the firm gives less time for
debtors.

2. Inventory / Stock Turnover:

The inventory turnover indicates whether inventory levels are reasonable in relation to cost of
goods sold. Inventory Turnover ratio is calculated as follows:

Inventory / Stock Turnover = Cost of Goods Sold


Average Inventory
Lower inventory turnover ratio relative to the industry standard may indicate excessive, obsolete,
or slow moving inventory, while higher turnover may indicate inadequate inventory and perhaps
possibility of inventory shortages.

3. Cash Conversion Cycle:

The cash conversion cycle shows the average number of days the cash is tied up in inventory and
receivables. Typically, a firm buys inventory, and cash is tied up in inventory for a number of
days before they are sold and converted in to receivables. Thus beyond the initial period in which
cash is tied up in inventory, there is an additional time period where cash is tied up in
receivables. However, firms are also able to obtain inventory on a credit basis, to that extent, the
firm does not tie up its own funds in building inventory. Hence, the total number of days cash is
tied up in inventory and receivables can be determined as follows.

Cash Conversion Cycle = Inventory processing days + Average collection period Payables
payment period
4. Fixed asset Turnover:

The fixed asset turnover ratio measures the efficiency of the use of fixed assets in generating
sales. It is computed as sales divided by average net fixed assets, where the average net fixed
assets is equal to the simple average of beginning and ending balance sheet values of net fixed
assets. Net fixed assets are gross fixed assets less accumulated depreciation.

Fixed Asset Turnover = Sales


Average net Fixed Assets
A lower fixed asset turnover relative to the industry may indicate that the firm carries excessive
fixed assets. A higher turnover may indicate inadequate, low, out dated or depreciated fixed
assets.

5. Total Asset Turnover:

Total asset turnover ratio measures the efficiency of the use of total assets in generating sales.
Total assets are sum of current and net fixed assets. The total asset turnover is calculated as sales
divided by average total assets. The average total assets are the simple average of total assets at
the beginning and end of the period.

Total Asset Turnover = Sales


Average Total Assets

3. Leverage ratios
The leverage ratios, also called debt management ratios, measure two key aspects of the use of
debt financing by the firm. The use of debt financing a called financial leverage. We want to
know the level of financial leverage used by the business as well as the ability of the firm to
service its debt obligations. The debt ratio, debt-equity ratio and interest cover is discussed
below.

1. Debt Ratio:

The debt ratio indicates the proportion of assets financed through both short-term and long-term
debt. This ratio is computed as total debt, which is the sum of short-term and long-term debt, as a
percentage of total assets. A higher ration indicates higher leverage. A higher ration also means
lower debt capacity in that the ability for the firm to raise funds through more debt is lower due
to already high debt levels.

Debt Ratio = Total Debt


Total Assets

2. Debt Equity Ratio:

The debt to equity ratio (D/E) is also widely used as an indication of the level of financial
leverage. While there are several ways of computing this ratio, the most useful version is to
express long term debt as percent of total equity. Thus it focuses only on the long-term financing,
both debt and equity, and it is meaningful when we want to examine the long-term leverage.
Total equity includes both preferred equity and common equity. A higher debt equity ratio
indicates greater leverage and potentially higher financial risk.

Debt Equity Ratio = Long Term Debt


Total Equity

3. Interest Cover:

The interest converge ratio, also known as the times-interest earned ( TIE), measures the ability
of firm`s current operating earnings (EBIT) to meet current interest obligations. It is the ratio of
EBIT to interest charge. The ratio shows number of times the interest payment are covered by the
firm`s operating earnings. The larger the coverage the better their ability of the firm to service
interest obligations on debt.

Interest Coverage = EBIT


Interest Charge
4. Profitability ratios
The profitability ratios, also known as performance ratios, assesses the firm`s ability to earn
profits on sales, assets and equity. These are critical to determining the attractiveness of investing
in company shares, and investors use these ratios widely. We will examine five important
profitability ratios, namely, gross profit margin, operating profit margin, net profit margin, return
on assets, and return on equity.

1. Gross Profit Margin:

The gross profit margin (GPM) shows the firm`s profit margin after deducting costs of goods
sold but before deducting operating expenses, interest expenses, and taxes. This ratio is also
known as gross profit ratio.

Gross Profit Margin = Sales Cost of Goods Sold


Sales
This is the first level of profitability. The GPM depends primarily on the firm`s product pricing
and cost control. The price of the product impacts sales. Production cost such as material, labour,
and overhead or the cost of purchases affect the cost of goods sold. A firm with a better ability to
price products in line with inflation of cost of production and the ability to control production
costs or suppliers will be able to maintain or increase gross margins.

2. Operating Profit margin:

The operating profit margin (OPM) shows the firm`s profit margin after deducting cost of goods
sold and operating expenses but before interest expenses and taxes. The operating profit is the
earnings before interest and taxes or EBIT as a percent of sales.

Operating Profit margin = EBIT


Sales
The OPM reflects the true profitability of firm`s business in that it is calculated before deducting
interest costs, which are a result from firm`s financing decision, and taxes, which are outside the
control of the firm. In other words, regardless of the way the firm is financed, whether through
debt or equity, and regardless of the taxes imposed by the government, the firm is able to earn
this margin.

3. Net Profit Margin:

This is the bottom line profitability, which most analysts and investors pay attention to on a
regular basis. The net profit margin (NPM) shows the firm`s profit margin after all the costs and
expenses. It is the profit available for distribution to common shareholders a percentage of sales.

Net Profit margin = Net Income


Sales

Obviously, the lower operating profit margin is one reason for the lower NPM. It is also possible
that, since the firm is more debt-financed than an average firm, it has more interest expenses as
well. Since taxes are fixed, the key difference between the OPM and NPM is interest costs,
which are linked to the firm`s financing decision.

4. Return on assets:

The return on assets (ROA) measures the return earned on total assets employed in the business.
Sometimes, this is also referred to as the return on total capital. Since total assets are financed
through both debt and equity, is important that the return measure used for this calculation
reflects income to both shareholders and debt holders. We define the return as the net income
available for distribution to shareholders plus the interest expenses paid to debt holders. This
return is divided by the average total assets, which represents the simple average of the total
assets at the beginning and ending balance sheets.

Return on assets = Net Income + Interest Expenses


Average Total Assets

5. Return on Equity:

The return on equity (ROE) measures the return earned on the capital provided by the common
stockholders (Equity holders). It is the net income as a percent of the average common equity,
where the average common equity is the simple average of the common equity at the beginning
and ending balance sheets. The net income is the income available for distribution to ordinary
shareholders after deducting any preferred dividends.

ROE = Net Income


Average Common Equity

5. Valuation ratios
The valuation ratios indicate the market valuation of a stock in terms of some measure of
company fundamentals such as earnings, book value, cash flows, and dividends. These are the
ratios that investors tend to look at on a daily basis. These ratios change whenever the price of
the stock changes. We will discuss the price/earnings ratios, the price/book value ratio, the
price/cash flow ratio, and dividend yield.

1. Price / Earnings ratio (P/E):

This is the most widely used valuation ratio. It indicates the market price of a share in terms of
earnings. It is the rupee amount an investor has to pay for each rupee of earnings made by the
firm for the ordinary shareholder.

P/E = Market Share per share


Earning per share

The earnings per share (EPS) is calculated as the net income available for ordinary shareholders
divided by the number of issued shares.

EPS = Net Income


Number of Shares

2. Price / Book Value Ratio (P/BV):

Price / Book Value is also a regularly reported and watched valuation ratio. It indicates the
market price of a share in terms of the book value of equity. It is the rupee amount an investor
has to pay for each rupee of book value.

P/BV = Market price per share


Book value per share

The book value per share is calculated as the equity divided by the number of ordinary shares
outstanding.
BV = Equity
Number of Shares

3. Price / Cash Flow Ratio:

The price/cash flow indicates the price of a share in terms of the cash flow per share. It shows
the rupee amount an investor has to pay for each rupee of cash flow generated.

P/CF = Market Price per Share


Cash Flow per Share

Although not widely reported, this is in fact a more useful ratio than the P/E and P/BV ratios
discussed earlier. This is because the price of a share must be related to the actual cash flows
generated by the firm to its shareholders. There are a number of different definitions of cash
flow, and the one we use here is the most basic definition of cash flow. The cash flow is the net
income available for ordinary shareholders adjusted for non-cash income and expenses included
in the income statement. Since most common non-cash item in the income statement is
depreciation of physical assets and amortization of intangible assets, the cash flow is calculated
by adding these two items to the net income.

Total cash flow = Net income + Depreciation & Amortization

CF = Total Cash Flow


Number of Shares
4. Dividend Yield (DY):

The dividend yield indicates the dividend income as a percentage of the investment. It is
calculated as the common dividend per share dividend by the market price per share.

DY = Dividend per share x 100


Market price per share

This is a particularly an important valuation measure for investors seeking regular income.
Investor who depend on income from their investments include retired persons and well as
pension and mutual funds, which invest with the primary objective of maximizing the income
return. These investors like to see a higher dividend yield. Typically, higher dividend yields are
associated with more stable and mature companies such as utilities. Growth -oriented companies
tend to pay lower dividends such as at a higher multiple, and as a result, produce lower dividend
yields. The dividend per share (DPS) is the total dividends to ordinary shareholders during a
specific period divided by the number of ordinary shares outstanding.

DPS = Total Ordinary Dividend


Number of Shares

Short Term Liquidity ratio & long term:

Liquidity Ratio may refer to:

Reserve requirement, a bank regulation that sets the minimum reserves each bank must
hold.

Quick Ratio (also known as an Acid Test or Liquidity Ratio), a ratio used to determine the
liquidity of a business entity
Liquidity ratio expresses a company's ability to repay short-term creditors out of its total cash. It
is the result of dividing the total cash by short-term borrowings. It shows the number of times
short-term liabilities are covered by cash. If the value is greater than 1.00, it means fully covered.
The formula is the following:
LR = liquid assets / short-term liabilities.
SHORT TERM LIQUIDITY RATIOS:

Short term liquidity ratios measure the ability of a company to pay off short term debts due in the
very near future and have enough money to finance its day to day business operations i.e., the
ability to survive in the short-run. The short term creditor of the company like supplies of goods
the credit and commercial bank providing short term loans are primarily interested in knowing
the company ability to meets its current obligation as and when they became due. The short term
obligation can only be met when there are sufficient liquid assets if the firm fail to meet such
obligation its good will be effected in the market and it will result in the loss of creditor
confident. But a very high liquidity position is not good because it means the firm has tied up
excessive fund in the current assets so it is very important to have a proper balance in regard to
the liquidity of the firm.

i) Current Ratio:
Current ratio is calculated by dividing current assets by current liabilities. This ratio shows that
how much current assets a company has against current liabilities. And how efficiently company
uses its current assets to generate more profit and higher ratio shows better performance. The
accepted benchmark for current ratio is 2:1. Current ratio above or below this level is not
acceptable for any company. If the current ratio is above this limit, that shows over capitalization
which shows too much investment in current assets thus reducing the profitability of the
company and current ratio below the benchmark limit is the sign of over trading which shows
that company is trying to expand its operations without strong cash base. Over trading is the
define sign of liquidity problems and current ratio below the benchmark limit shows that
company might not be able to pay off its liabilities on due date thus liquidation may follow.
ii) Quick Ratio:
Quick ratio is also known as Acid test ratio. This ratio is calculated by dividing current assets
excluding stocks by current liabilities. The reason for exclusion of stock is the fact that stock is a
least liquid asset. The acceptable benchmark for quick ratio is 1:1. This ratio measures the ability
of a company to use its near cash or quick assets to immediately extinguish its current liabilities.
Quick assets include those current assets that apparently can be quickly converted to cash at
close to their book values. Such items are cash, marketable securities, and some accounts
receivable. This ratio indicates a firm's capacity to maintain operations as usual with current cash
or near cash reserves in bad periods. As such, this ratio implies a liquidation approach and does
not recognize the revolving nature of current assets and liabilities. The ratio compares a
company's cash and short-term investments to the financial liabilities the company is expected to
incur within a year's time.
Advantages and Disadvantages of Current Ratio:
The current ratio is one of the most useful ratios in financial analysis as it helps to gauge the
liquidity position of the business. In simple words, it shows a companys ability to convert its
assets into cash to pay off its short-term liabilities. The article discusses different advantages and
disadvantages of current ratio.
It is calculated as a ratio of a companys current assets to its current liabilities. The current ratio
is widely used by banks and financial institutions while sanctioning loans to the companies and
therefore this is a vital ratio for any company. There are different ways of analysing and
improving current ratio to portray a better liquidity position of a company.
Along with knowing how to analyse and improve current ratio, it is important to know the
advantages and disadvantages of using current ratio.
Advantages of Current Ratio:

o Current ratio helps in understanding how cash rich a company is. It helps us gauge the
short-term financial strength of a company. Higher the ratio, more stable the company is.
Lower the ratio, greater is the risk of liquidity associated with the company.

o The current ratio gives an idea of a companys operating cycle. It helps in


understanding how efficient the company is in selling off its products; that is, how quickly
is the company able to convert its inventory or current assets into cash. Knowing this, a
company can optimize its production. This enables the company to plan inventory storage
mechanisms and optimize the overhead costs.

o Current ratio as shows the managements efficiency in meeting the creditors demands.
It gives an understanding of working capital management / requirement of the company.

Disadvantages of Current Ratio:


o Using this ratio on a standalone basis may not be sufficient to analyse the liquidity
position of the company as it relies on the quantity of current assets instead of the quality of
the asset.
o Current ratio includes inventory in the calculation, which may lead to overestimation of
the liquidity position in many cases. In companies, where higher inventory exists due to less
sales or obsolete nature of the product; taking inventory under calculation may lead to
displaying incorrect liquidity health of the company.
o In companies where sales are seasonal; current ratio may show lower numbers in some
months and higher current ratio in the other.
o Current Ratio may be impacted due to change in inventory valuation methodology by
the company. Such will not be a case while using the Acid test ratio since it does not
consider inventory at all.
o An equal increase or decrease in the current assets and current liabilities can change the
ratio. Hence, an overdraft against inventory can cause the current ratio to change. Hence, it
is very easy to manipulate current ratio.

Current ratio: Introduction

The current ratio measures a companys current assets against its current liabilities. The current
ratio indicates if the company can pay off its short-term liabilities in an emergency by liquidating
its current assets. Current assets are found at the top of the balance sheet and include line items
such as cash and cash equivalents, accounts receivable and inventory, among others.

A low current ratio indicates that a firm may have a hard time paying their current liabilities in
the short run and deserves further investigation. A current ratio under 1.00 xs, for example,
means that even if the company liquidates all of its current assets, it would still be unable to
cover its current liabilities. In our example, the firm is operating with a very low current ratio of
0.91x. It indicates that if the firm liquidated all of its current assets at the recorded value, it
would only be able to cover 91% of its current liabilities.

A high ratio indicates a high level of liquidity and less chance of a cash squeeze. A current ratio
that is too high, however, may indicate that the company is carrying too much inventory,
allowing accounts receivables to balloon with lax payment collection standards or simply
holding too much in cash. Although these issues will not typically lead to insolvency, they will
inevitably hurt the companys bottom line.

What is the 'Current Ratio?'

The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-
term obligations. To gauge this ability, the current ratio considers the current total assets of a
company (both liquid and illiquid) relative to that companys current total liabilities.

Meaning: Current ratio

The current ratio is a liquidity ratio that measures a company's ability to pay short-term and
long-term obligations. To gauge this ability, the current ratio considers the current total assets
of a company (both liquid and illiquid) relative to that company's current total liabilities.

Limitations of current ratio


Current ratio suffers from a number of limitations. Some are given below:
1. Different ratio in different parts of the year:
Some businesses have different trading activities in different seasons. Such businesses may show
low current ratio in some months of the year and high in others.
2. Change in inventory valuation method:
To compare the ratio of two companies it is necessary that both the companies use same
inventory valuation method. For example, comparing current ratio of two companies would be
like comparing apples with oranges if one uses FIFO cost flow assumption and the other
uses LIFO cost flow assumption for the valuation of inventories. The analyst would, therefore,
not be able to compare the ratio of two companies even in the same industry.
3. Current ratio is a test of quantity, not quality:
It is not an exact science to test liquidity of a company because the quality of each individual
asset is not taken into account while computing this ratio.

Meaning: Quick Ratio:

The quick ratio is a measure of how well a company can meet its short-term financial liabilities.
Also known as the acid-test ratio, it can be calculated as follows: (Cash + Marketable Securities
+ Accounts Receivable) / Current Liabilities.

What is the 'Quick Ratio?'


The quick ratio is an indicator of a companys short-term liquidity. The quick ratio measures a
companys ability to meet its short-term obligations with its most liquid assets.

Advantages and Disadvantages of Acid Test Ratio/ Quick Ratio:

Acid Test ratio is the ratio which measures the liquidity of a company and its ability to take care
of its short-term liabilities. This ratio is an improvised version of the current ratio and tries to
do away with the limitations of the current ratio. The Acid test ratio is also called as a Quick
ratio. The article discusses advantages and disadvantages of acid test ratio / quick ratio.
Advantages of Acid Test Ratio
o The acid test ratio removes the inventory from the calculation, which may not always
be considered liquid, thereby giving a more appropriate picture of the companys liquidity
position.
o Since inventory is excluded from current assets; bank overdraft and cash credit are
removed from current liabilities as they are usually secured by inventory thereby making the
ratio more meaningful in arriving at the liquidity position of the company.
o Valuation of inventory can be tricky and it may not always be at marketable value.
Thus, acid test ratio is not handicapped as there is no need for valuation of the inventory.
o Inventory can be very seasonal in nature and may vary in quantity over a yearly period.
If considered, it may deflate or inflate liquidity position. By avoiding inventory from the
calculation, acid test ratio does away with this problem.
o In a dying industry, which usually may have very high level of inventory; this ratio will
provide more reliable repayment ability of the company as against the current ratio which
includes inventory.
Disadvantages of Acid Test Ratio
o Using this ratio on a standalone basis may not be sufficient to analyse the liquidity
position of the company. A comparative analysis with the peers and industry standard may
be required for effective analysis.
o This ratio removes inventory from the calculation, which may not be appropriate for
businesses where inventory can be valued at a marketable price easily. It should rather be
included than excluded to arrive at the liquidity position of the company.
o This ratio may not be a good indicator for all business models for showing short term
solvency because if companies with usually higher inventory, like supermarkets
exclude inventory to arrive at liquidity position, it may not be essentially correct to do
so.
o The acid test ratio ignores the level and the timing of the cash flows which actually
would be a major parameter determining the companys ability to pay liabilities when
they become due.
o The ratio considers accounts receivables as liquid and can be easily converted to cash
which may not always be the case.

Quick ratio: Introduction

The quick ratio is a liquidity ratio that is more stringent than the current ratio. This ratio
compares the cash, short-term marketable securities and accounts receivable to current liabilities.
The thought behind the quick ratio is that certain line items, such as prepaid expenses, have
already been paid out for future use and cannot be quickly and easily converted back to cash for
liquidity purposes. In our example, the quick ratio of 0.45 xs indicates that the company can only
cover 45% of current liabilities by using all cash-on-hand, liquidating short-term marketable
securities and monetizing accounts receivable.

The major line item excluded in the quick ratio is inventory, which can make up a large portion
of current assets but may not easily be converted to cash. During times of stress, high inventories
across all companies in the industry may make selling inventory difficult. In addition, if
company stockpiles are overly specialized or nearly obsolete, they may be worth significantly
less to a potential buyer. Consider Apple Inc. (AAPL), for example, which is known to use
specialized parts for its products. If the company needed to quickly liquidate inventory, the
stockpiles it is carrying may be worth a great deal less than the inventory figure it carries on its
accounting books.

Capital Gearing Ratio: Meaning


The gearing ratio measures the proportion of a company's borrowed funds to its equity.
The ratio indicates the financial risk to which a business is subjected, since excessive debt can
lead to financial difficulties.

Gearing Ratio: Introduction

The gearing ratio measures the proportion of a company's borrowed funds to its equity. The ratio
indicates the financial risk to which a business is subjected, since excessive debt can lead to
financial difficulties. A high gearing ratio represents a high proportion of debt to equity, and a
low gearing ratio represents a low proportion of debt to equity. This ratio is similar to the debt to
equity ratio, except that there are a number of variations on the gearing ratio formula that can
yield slightly different results.

A high gearing ratio is indicative of a great deal of leverage, where a company is using debt to
pay for its continuing operations. In a business downturn, such companies may have trouble
meeting their debt repayment schedules, and could risk bankruptcy. The situation is especially
dangerous when a company has engaged in debt arrangements with variable interest rates, where
a sudden increase in rates could cause serious interest payment problems.

A high gearing ratio is less of a concern in a regulated industry, such as a utility, where a
business is in a monopoly situation and its regulators are likely to approve rate increases that will
guarantee its continued survival.

Lenders are particularly concerned about the gearing ratio, since an excessively high gearing
ratio will put their loans at risk of not being repaid. Possible requirements by lenders to
counteract this problem are the use of restrictive covenants that prohibit the payment of
dividends, force excess cash flow into debt repayment, restrictions on alternative uses of cash,
and a requirement for investors to put more equity into the company. Creditors have a similar
concern, but are usually unable to impose changes on the behaviour of the company.

Those industries with large and on-going fixed asset requirements typically have high gearing
ratios.

A low gearing ratio may be indicative of conservative financial management, but may also mean
that a company is located in a highly cyclical industry, and so cannot afford to become
overextended in the face of an inevitable downturn in sales and profits.

What is 'Capital Gearing'?


Capital gearing is the degree to which a company acquires assets or to which it funds its on-
going operations with long- or short-term debt. Capital gearing will differ between companies
and industries, and will often change over time.

How to Calculate the Gearing Ratio

The most comprehensive form of gearing ratio is one where all forms of debt - long term, short
term, and even overdrafts - are divided by shareholders' equity. The calculation is:

Long-term debt + Short-term debt + Bank overdrafts


Shareholders' equity

Another form of gearing ratio is the times interest earned ratio, which is calculated as shown
below, and is intended to provide some indication of whether a company can generate enough
profits to pay for its on-going interest payments.

Earnings before interest and taxes


Interest payable

Another variation on the gearing ratio is the long-term debt to equity ratio; it is not especially
useful when a company has a large amount of short-term debt (which is especially common
when no lenders are willing to commit to a long-term lending arrangement). However, it can be
of use when the bulk of a company's debt is tied up in long-term bonds.

Significance of Capital Gearing:

The problem of capital gearing is very important in a company. It has a direct bearing on the
divisible profits of a company and hence a proper capital gearing is very important for the
smooth running of an enterprise.

In case of low geared company, the fixed cost of capital by way of fixed dividend on preference
shares and interest on debentures is low and the equity shareholders may get a higher rate of
dividend. Whereas, in a high geared company the fixed cost of capital is higher leaving lesser
divisible profits for the equity shareholders.

The capital gearing in the financial structure of a business has been rightly compared with the
gears of an automobile. The gears are used to maintain the desired speed and control. Initially, an
automobile starts with a low gear, but as soon as it gets momentum, the low gear is changed to
high gear to get better speed.

Similarly, a company may be started with high equity state, i.e. low gear but after momentum, it
may be changed to high gear by mixing more of fixed interest bearing securities such as
preference shares and debentures.

It may also be noted that capital gearing affects not only the shareholders but the debenture
holders, creditors, financial institutions, the financial managers and others are also concerned
with the capital gearing.

Capital Gearing and Trade Cycles:

The technique of capital gearing can be successfully employed by a company during various
phases of trade cycles, i.e., during the conditions of inflation and deflation, to increase the rate of
return to its owners (equity shareholders) and thereby increasing the value of their investments.

The effect of capital gearing during various phases of trade cycles is discussed below:

i. During Inflation or Boom Period:

A company should follow the policy of high gear during inflation or boom period as the profits
of the company are higher and it can easily pay fixed costs of debentures and preferences shares.

Further, during boom period, the rate of earnings of the company is usually higher than the fixed
rate of interest/dividend prevailing on debentures and preferences shares. By adopting the policy
of high gear, a company can increase its earnings per share and thereby a higher rate of dividend.

ii. During Deflation or Depression Period:

During depression the rate of earnings of the company is lower than the rate of interest/dividend
on fixed interest bearing securities and hence it cannot meet the fixed costs without lowering the
divisible profits and rate of dividend. It is, therefore, better for a company to remain in low gear
and not to resort to fixed interest bearing securities as source of finance during such period.
Fixed Asset to Capital ratio:

A ratio used to calculate a business's ability to satisfy long-term debt. The value of the fixed
assets is divided by the equity capital; a ratio greater than 1 means that some of the fixed
assets are financed by debt.

The Fixed Asset-To-Equity Capital Ratio

Businesses can rely on many measures to determine how financially healthy they are.
Calculating their fixed-asset-to-equity-capital ratio is one way. This ratio determines whether a
company's fixed assets are worth more than the amount of money that investors have sunk into
it. Stronger companies have positive fixed-asset-to-equity-capital ratios. They might also have an
easier time attracting the dollars of future investors.

Defining the Ratio:

The fixed-asset-to-equity-capital ratio is made up of two parts: fixed assets and equity capital. A
business's fixed assets are any type of physical assets that have an expected lifetime of at least
one year. Buildings, vehicles, furniture and heavy equipment are all examples of fixed assets.
Equity capital is the money that investors have put into a company. As a reward for these funds,
investors receive part ownership of a business. These investors then hope that the business
thrives and that the value of their shares in a company increases.
Calculating the Ratio:

It's relatively simple for businesses to calculate their fixed-asset-to-equity-capital ratios: They
only have to divide the total value of their fixed assets by the total value of equity capital. A
business that has $10,000 worth of fixed assets and $8,000 worth of equity capital would have a
fixed-asset-to-equity-capital ratio of 1.25. A business with $10,000 worth of fixed assets but
$15,000 worth of equity capital has a ratio of 0.66. Any time this ratio is 1 or higher, a company
has a positive fixed-asset-to-equity-capital ratio. When the number is lower than 1, a company
has negative ratio.

The Ratio's Importance:

This particular ratio is important because it can either help or hurt businesses in their efforts to
attract additional investors. Businesses with a positive fixed-asset-to-equity-capital ratio are
considered less risky. Such businesses might have an easier time convincing potential investors
to part with their dollars.

Why Use This Ratio?

Businesses have other methods of determining their financial strength. But the fixed-asset-to-
equity-capital ratio provides a snapshot of how financially strong a company would be if its
revenues, for whatever reason, dried up. Companies with a high ratio know that they at least
have valuable fixed assets that they can turn into cash if needed.

A fixed asset to equity ratio measures the contribution of stockholders and the contribution of
debt sources in the fixed assets of the company. It is computed by dividing the fixed assets by the
stockholders equity.

Other names of this ratio are fixed assets to net worth ratio and fixed assets to proprietors fund
ratio.

Formula:

The numerator in the above formula is the book value of fixed assets (fixed assets less
depreciation) and the denominator is the stockholders equity that consists of common stock,
preferred stock, paid in capital and retained earnings. Information about fixed assets and
stockholders equity is available from balance sheet.

Significance and interpretation:

If fixed assets to stockholders equity ratio is more than 1, it means that stockholders equity is
less than the fixed assets and the company is using debts to finance a portion of fixed assets. If
the ratio is less than 1, it means that stockholders equity is more than the fixed assets and
the stockholders equity is financing not only the fixed assets but also a part of the working
capital.

Different industries have different norms. Generally a ratio of 0.60 to 0.70 (or 60% to 70%, if
expressed in percentage) is considered satisfactory for most of the industrial undertakings.

Fixed assets to stockholders equity ratio is used as a complementary ratio to proprietary ratio.

Meaning: Interest Coverage Ratio

The interest coverage ratio (ICR) is a measure of a company's ability to meet its
interest payments. Interest coverage ratio is equal to earnings before interest and taxes (EBIT)
for a time period, often one year, divided by interest expenses for the same time period.

What is the 'Interest Coverage Ratio'

The interest coverage ratio is a debt ratio and profitability ratio used to determine how easily a
company can pay interest on outstanding debt. The interest coverage ratio may be calculated by
dividing a company's earnings before interest and taxes (EBIT) during a given period by the
amount a company must pay in interest on its debts during the same period.

The method for calculating interest coverage ratio may be represented with the following
formula:

or
Interest coverage ratio: introduction

The interest coverage ratio, also known as times interest earned, measures a companys cash
flows generated compared to its interest payments. The ratio is calculated by dividing EBIT
(earnings before interest and taxes) by interest payments.

In the example used in Table 1, the interest coverage ratio of 2.3 xs indicates that the firms
earnings before interest and taxes are 2.3 times its interest obligations for the period. The higher
the figure, the less chance a company has of failing to meet its debt repayment obligations. A
high figure means that a company is generating strong earnings compared to its interest
obligations.

With interest coverage ratios, its important to analyse them during good and lean years. Most
companies will show solid interest coverage during strong economic cycles, but interest
coverage may deteriorate quickly during economic downturns.

Uses of 'Interest Coverage Ratio'

While looking at a single interest coverage ratio may tell a good deal about a companys current
financial position, analyzing interest coverage ratios over time will often give a much clearer
picture about a companys position and trajectory. By analyzing interest coverage ratios on a
quarterly basis for the past five years, for example, trends may emerge and give an investor a
much better idea of whether a low current interest coverage ratio is improving or worsening, or if
a high current interest coverage ratio is stable. The ratio may also be used to compare the ability
of different companies to pay off their interest, which can help when making an investment
decision.

Generally, stability in interest coverage ratios is one of the most important things to look for
when analyzing the interest coverage ratio in this way. A declining interest coverage ratio is often
something for investors to be wary of, as it indicates that a company may be unable to pay its
debts in the future.

Overall, interest coverage ratio is a very good assessment of a companys short-term financial
health. While making future projections by analyzing a companys interest coverage ratio history
may be a good way of assessing an investment opportunity, it is difficult to accurately predict a
companys long-term financial health with any ratio or metric.

Variations of 'Interest Coverage Ratio'

There are a couple of somewhat common variations of interest coverage ratio that are important
to consider before studying the ratios of companies. These variations come from alterations to
EBIT in the numerator of interest coverage ratio calculations.

One such variation uses earnings before interest, taxes, depreciation and amortization
(EBITDA) instead of EBIT in calculating the interest coverage ratio. Because this variation
excludes depreciation and amortization, the numerator in calculations using EBITDA will often
be higher than those using EBIT. Because the interest expense will be the same in both cases,
calculations using EBITDA will produce a higher interest coverage ratio than calculations using
EBIT will.

Another variation uses earnings before interest after taxes (EBIAT) instead of EBIT in interest
coverage ratio calculations. This has the effect of deducting tax expenses from the numerator in
an attempt to render a more accurate picture of a companys ability to pay its interest expenses.
Because taxes are an important financial element to consider, for a clearer picture of a companys
ability to cover its interest expenses one might use EBIAT in calculating interest coverage ratios
instead of EBIT.

All of these variations of calculating the interest coverage ratio use interest expenses in the
denominator. Generally speaking, these three variants increase in conservatism, with those using
EBITDA being the most liberal, those using EBIT being more conservative, and those using EBI
being the most stringent.

Limitations of 'Interest Coverage Ratio'

Like any metric attempting to gauge the efficiency of a business, the interest coverage ratio
comes with a set of limitations that are important for any investor to consider before using it.
For one, it is important to note that interest coverage is highly variable, both when measuring
companies in different industries and even when measuring companies within the same industry.
For established companies in certain industries, like a utility company, an interest coverage ratio
of 2 is often an acceptable standard. Even though this is a low number, a well-established utility
will likely have very consistent production and revenue, particularly due to government
regulations, so even with a relatively low interest coverage ratio it may be able to reliably cover
its interest payments. Other industries, like many kinds of manufacturing, are much
more volatile and may often have a higher minimum acceptable interest coverage ratio, like 3.
These kinds of companies generally see greater fluctuation in business. For example, during the
recession of 2008, car sales dropped substantially, hurting the auto manufacturing industry. A
workers strike is another example of an unexpected event that may hurt interest coverage ratios.
Because these industries are more prone to these fluctuations, they must rely on a greater ability
to cover their interest in order to account for periods of low earnings. Because of wide variations
like these, when comparing companies interest coverage ratios one should be sure to only
compare companies in the same industry, and ideally when the companies have similar business
models and revenue numbers as well.

While all debt is important to take into account when calculating the interest coverage ratio,
companies may choose to isolate or exclude certain types of debt in their interest coverage ratio
calculations. As such, when considering a companys self-published interest coverage ratio, one
should try to determine if all debts were included, or should otherwise calculate interest coverage
ratio independently.

To understand more on the importance of this ratio, read Why Interest Coverage Matters to
Investors and Debt Ratios: Interest Coverage Ratio.
COMPUTATION OF B/S RATIOS AT A GLANCE

ITEM AMOUNT
I. SOURCES OF
FUNDS
1. Equity share EC
capital
2.

RS
3. EF
Reserves &surplus
4.
PC
5. Equity shareholders PF
funds (1+2). CE
6.
Preference share BF
7. capital

Proprietors funds (3+4)


.

Borrowed funds
. FA
Capital Employed (6+7) DR

BR
II. USE OF FUNDS
1. Fixed Assets OQ
.. A
2.
Debtors QA
3.

CST
4. CA
PP
5. Bills Receivable
.
6.
Other Quick Assets CD
7. .
BP
8. Total Quick Assets
(2+3+4) OQ
9.
L
Closing Stock
10. CL
.. QL
11. WC
Pre-payments OD
12. .

13. Current Assets (5+6+7)


..
14.
Creditors
15.
16. CE
Bills payable

Other Quick Liabilities


Total Quick Liabilities


(9+10+11)..

Bank
Overdraft..

Current Liabilities
(12+13)

Working Capital (8-14)


.

Capital Employed (1+15)


..

Balance Sheet Ratio Equation / Formula

1. Current Ratio CR = CA/CL

2. Quick / Liquid Ratio QR = QA/QL

3. Stock Working Capital SWC = CST/WC *100

4. Proprietors Ratio PR = PF / TA * 100


[TA = Total Assets = FA +CA =CE +CL =
Total of Horizontal
B/S Fictitious Assets]

5. Debt Equity Ratio DER = BF/PF

6. Capital Gearing Ratio CGR = PC + BF


EF
REVENUE STATEMENT RATIOS

COMPUTATION OF P/L RATIO AT A GLANCE

INCOME STATEMENT

PARTICULAR AMOUNT
1. Credit Sales CRS
2. Cash Sales
3. Total Sales (1+2) CAS
4. Opening Stock
5. Credit Purchases OST
6. Cash Purchases
P
BIBLIOGRAPHY

o Manan Prakashan

o Sheth Publisher

o www.mu,ac.in

o http://www.myaccountingcourse.com/financial-ratios/liquidity-ratios

o http://www.myaccountingcourse.com/financial-ratios/liquidity-ratios

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