1. Chapter 4 Ratio Analysis : INTRODUCTION & LIQUIDITY RATIOS

April 07, 2020

Lets begin with Ratio Analysis:

Chapter 4

Ratio Analysis

Learning Objectives:
The study material of this class would enable you to understand:
* The meaning of Ratio Analysis
* Objectives of Ratio Analysis
* Classification of Types of Accounting Ratios
* Working of the first type of the Accounting Ratios :
* Liquidity ratios : Current ratio and Liquid ratio

Meaning of Ratio Analysis ratio analysis describes the significant relationship which exists between various items of a balance sheet and statement of profit and loss of a firm. It is possible to assess the profitability, solvency and efficiency of a firm through the technique of ratio analysis.

Objectives of Ratio analysis
1. To provide a deeper Analysis of profitability, liquidity solvency and efficiency levels in the business.
2. To provide information for making cross-sectional analysis by comparing the performance with the best industry standards.
3. To know about the potential areas which can be improved with the effort of the design direction
4. To provide information derived from financial statements useful for making projections and estimates for future.

Classification of Accounting Ratios

1. Liquidity Ratios

..to make its commitments business needs liquid funds. Liquidity of business refers to the firm's ability to meet its current obligations /short term liabilities, and the ratios calculated to measure it are known as 'liquidity ratios'. These are essentially short term in nature.
2. Solvency Ratios

..solvency of business is determined by its ability to meet its contractual obligations towards stakeholders particularly towards external state holders and the ratios calculated to measure solvency position are known as 'Solvency ratios'. These are essentially long-term in nature.
3. Activity or turnover ratios

.. are calculated for measuring the efficiency of operations of business based on effective utilisation of resources. Hence,these are also known as efficiency ratios.
4. Profitability ratios..profitability refers to the analysis of profits in relation to revenue from operations of funds (or assets) employed in the business and the ratios calculated to meet this objective are known as profitability ratios.

We Will Firstly Start With the LIQUIDITY RATIOS
I.Liquidity ratios

1 Current ratio.. current ratio is the ratio of current assets to current liabilities.
current assets ..include current investments inventories ,trade receivables (debtors and bills receivable), cash and cash equivalents ,short term loans and advances and other current assets such as prepaid expenses, advance tax and accrued income etc.
current liabilities include short term borrowings, trade payables (creditors and bills payable) other current liabilities and short term provisions.

Significance .. a very high current ratio implies heavy investment in current assets which is not a good sign as it reflects under utilization or in proper utilisation of resources.
A low current ratio endangers the business and puts it at risk of facing a situation where it will not be able to pay its short term debt on time. If this problem persists, it may affect firm's creditworthiness adversely.
Normally it is safe to have current ratio between the range of

2 : 1.

2.Quick ratio or liquid ratio or acid test ratio

quick ratio is equal to quick assets divided by current liabilities. quick assets are defined as those assets which are quickly convertible into cash.

While calculating quick assets we exclude the inventory is at the end and other current assets such as prepaid expenses advance tax etc. from the current assets because they are not quickly convertible into cash, and hence considered as non liquid current assets.
Quick assets = current assets - closing inventory - other current assets( prepaid expenses advance tax etc.)

Alternatively, quick assets = current investments + trade receivables + cash and cash equivalents + short term loans and advances

Significance.. the quick ratio provides a measure of the capacity of the business to meet its short-term obligations without any flaw.
unnecessarily low ratio will be very risky and high ratio suggests unnecessary deployment of resources in otherwise less profitable short term Investments.
Normally it is safe to have quick ratio of 1: 1.

Ratio Analysis – Questions

Ques. 1 (EXAMPLE)

Calculate Current ratio from the following information:
inventory                                                           50,000
trade receivables                                             50000
advance tax                                                       4000
cash and cash equivalents                             30,000

trade payables 100000
short term borrowings (bank overdraft ) 4000

Ans. 1.29 : 1

Answer. 1
current ratio = current assets / current liabilities

current assets = inventory + trade receivables + advance tax + cash and cash equivalents

=50000 + 50000 + 4000 + 30000 = 134000
current liability = trade payables + short term borrowings

= 100000 + 4000= 104000
therefore current ratio = 134000 /104000

= 1.29 :1

Ques. 2 (EXAMPLE)

Calculate quick ratio from the following..
inventory                                                                   50,000
trade receivables                                                         50000 advance tax                                                                   4000
cash and cash equivalents                                         30,000

trade payables 100000
short term borrowings (bank overdraft) 4000

Answer. 2
quick ratio = quick assets /current liabilities
Quick assets = trade receivables + cash and cash equivalent

= 50000 + 30000 = 80000
current liabilities = trade receivables + short term borrowings (bank overdraft)

= 100000 + 4000 = 104000

therefore quick ratio = 80000/ 104000 = 0.77:1

Task 3. Do the Assignment given below with the reference to the examples, notes and formulas shared above:

Assignment #1

Ques. 1

From the following compute current ratio:

current investments 40,000

short term provisions 3000

inventory 5000

other current liabilities 5000

trade receivables 2000

short term loans and advances 4000

short term borrowings 20000

tangible fixed assets 100000

trade payables 2500

cash and cash equivalents 10000

prepaid expenses 2000

advance tax 8000

Ans. 2.32 : 1

Ques 2.

Calculate current ratio and liquid ratio:
liquid assets                                               75000
inventory (includes loose tools of 20,000 )35,000
prepaid expenses                                        10,000
working capital                                           60000

Ans. 2.5 :1 , 1.875:1

Verify the Answers to the Assignment # 1 and make Corrections.

Ans1.
current ratio = current assets/ current liabilities
current assets = current investments + inventory + trade receivables + short term loans and advances + cash and cash equivalents + prepaid expenses + advance tax
= 40000 + 5000 + 2000 + 4000 + 10000 + 2000 + 8000 = 71000
current liabilities = short term provisions + other current liabilities + short term borrowings + trade payables
= 3000 + 5000 + 20000 + 2500 = 30500
current ratio = 71000/30500 = 2.32 : 1

Ans. 2.
current assets = liquid assets + inventories ( excluding loose tools) + prepaid expenses
=75000 + 15000 + 10000 = 100000
working capital = current assets - current liabilities
therefore current liabilities = current assets - working capital
= 100000 - 60000 = 40000
current ratio = current assets/ current liabilities
= 100000/40000 = 2.5:1

liquid ratio = liquid Assets / current liabilities
= 75000 / 40,000 = 1.875 :1