9.Liquidity Ratios, Solvency Ratios Revised

Hello Gentlemen!

Learning Objectives:
To revise the covered portion of the chapter before going ahead:

Liquidity Ratios:
1.Current Ratio
2.Quick Ratio

Solvency Ratios:

1. Liquidity Ratio
2. Proprietary Ratio
3. Total Assets to Debt Ratio
4. Interest Coverage Ratio

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Recapitulation (Ratio Analysis)

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:

Normally it is safe to have current ratio between the range of

 2 : 1.

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Quick Ratio( Liquid Ratio)

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Solvency Ratios:Debt Equity

1. Debt Equity ratio measures the relationship between long term debt and shareholders funds. It is computed as long term debts divided by shareholders funds where long term debts (also termed as debt) = non current liabilities
= long term borrowings + other long term liabilities + long term provision

shareholders funds (also termed as equity) = share capital + reserves and surplus + money received against share warrants
Significance.. this ratio measures the degree of indebtedness of an enterprise and gives an idea to the long term lender regarding extent of security of the debt. 

Normally, believe it is considered to be safe if debt equity ratio is 2:1. however, it may vary from industry to industry.

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Proprietary, Total Asset to Debt,Interest coverage

2. Proprietary ratio..

 expresses relationship of shareholders' funds (proprietors' funds )to total assets and is calculated as follows..
= shareholders' funds divided by total assets
Significance.. higher proportion of shareholders funds in financing the total asset is a positive feature as it provides security to creditors.

3. Total assets to debt ratio..

this ratio measures the extent of the coverage of long-term debts by assets. It is calculated as total assets divided by long term debts

Significance.. this ratio primary indicates the rate of external funds in financing total assets and the extent of coverage of long term debts by assets. The higher ratio indicates that assets have been mainly financed by owners' funds and long term loans is adequately covered by assets.

4. Interest coverage ratio..
it is a ratio of which deals with the servicing of interest on long term debts. It is a measure of security of interest payable on long term debts.
It expresses the relationship between profits available for payment of interest and the amount of interest payable.
Interest coverage ratio = net profit before interest and tax/ interest on long term debts
Significance..It reveals the number of times interest on long term debts is covered by the profits available for payment of interest. A higher interest coverage ratio ensure safety of interest on debts.

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IMPORTANT NOTE

Boys, though companies have VERTICAL layout of Balance Sheet. For understanding only,  the balance sheet of the company  with data arranged HORIZONTALLY is placed below.

The first balance sheet is placed with headings and subheadings of the liability and asset side.

2nd balance sheet shows only the headings of the liability and the Asset side.

Heading 2 on the liability side of the balance sheet is -  'Share application money pending allotment' has been removed from the balance sheet, as it is not in the syllabus.

So boys, understand the formulas given above for the various ratios in reference to the balance sheets given. 

                               Balance Sheet of Company

     

I.Equity and Liabilities 1.     Shareholders’ Funds (a) Share capital                                                       (b) Reserves and surplus                                         (c) Money received against share warrants             2. Share application money pending allotment 3. Non current liabilities (a) Long term borrowings                                        (b) Deferred tax liabilities (net)                                (c) Other long term liabilities                                   (d) Long term provisions                                         4.Current liabilities  (a)Short term borrowings  (b)Trade payables  (c)Other current liabilities  (d)Short term provisions 2.       Total

II.Assets 1.Non current assets  (a)Fixed assets  (i)tangible assets  (ii)intangible assets  (iii)capital work in progress  (iv)intangible assets under development (b)Non current investments  (c) Deferred tax assets (net) (d) Long term loans and advances (e)Other non current assets 2. Current assets  (a)Current investments  (b)Inventories (c)Trade receivables  (d)Cash and cash equivalents  (e)Short term loans and advances (f)Other current assets  Total

                               Balance Sheet of Company

I.Equity and Liabilities 1.     Shareholders’ Funds 2.     Non current liabilities 3.Current liabilities            Total

II.Assets 1. Non current assets  2. Current assets  Total