Ratio Analysis – Part 2 Liquidity Ratios Paper 3B: Financial Management Chapter 3 Unit I

CA B. Hari Gopal B.com, PGDBA, FCA, FCMA, DISA(ICAI), PMP (PMI, USA), EPBM (IIMC), MCT

Learning Objectives

1. Gain Knowledge on Liquidity Ratios

2. Usage of various Liquidity Ratios

3. Preparation of various Liquidity Ratios

2

Introduction to Liquidity Ratios

•Background •Types of Liquidity Ratios

3

4

Liquidity Ratio - Background

Liquidity and Short term solvency

Meaning of Liquidity

Impact of inability to pay short term liabilities

5

Types of Liquidity Ratios

6

Current Ratio

Quick Ratio

Cash Ratio / Absolute Liquidity Ratio

Basic Defense Interval

Net Working Capital Ratio

Current ratio

7

Current Ratio

8

A ratio of less than 1 is a cause of concern, particularly if it persists for long time

Acceptable current ratio is 2 to 1.

Formulae - Current assets / Current liabilities

A simple measure that estimates whether the business can pay debts due within 1 year from assets that it

expects to turn in to cash within that year

Current Assets & Current Liabilities

9

• Inventories + Receivables + Cash and Bank Balances + Loans and Advances +Disposable investments + Accruals

Current Assets

• Creditors for goods and services + Short Term Loans + Bank Overdraft + Cash Credit + Outstanding expenses + Provision for Taxation + proposed Dividend + Unclaimed Dividend

Current Liabilities

Illustration 1 – Current Ratio

10

Extract of BALANCE SHEET OF M/s HPCL Ltd as at 31-Mar-2009

Rs. Rs. Fixed Assets (Net Block) 30,000 Debtors 50,000 Cash at Bank 10,000 Stock 60,000 Total Current Assets (CA) 1,20,000 Creditors 50,000 Total Current Liabilities (CL) 50,000 Working Capital (CA-CL) 70,000 Total Assets 1,00,000 Find Current Ratio

Illustration 1 – Current Ratio 11

Current Ratio = Current Assets / Current Liabilities

Current Ratio 2.40

Current Assets Debtors 50,000 Cash at Bank 10,000 Stock 60,000

1,20,000

Current Liabilities

Creditors 50,000

Quick ratio

12

Quick Ratio

Other names – Acid Test Ratio or Liquid Ratio

It adjust the current ratio to eliminate all assets that are not already in cash or near cash form.

Formulae – Quick assets / Current liabilities

Acceptable Quick ratio is 1 to 1 is considered as satisfactory. A ratio of less than 1, would be a danger signal

13

Quick Assets & Current Liabilities

14

• Receivables + Cash and Bank Balances + Loans and Advances +Disposable investments + Accruals

Quick Assets

• Creditors for goods and services + Short Term Loans + Bank Overdraft + Cash Credit + Outstanding expenses + Provision for Taxation + proposed Dividend + Unclaimed Dividend

Current Liabilities

Illustration 2 – Quick Ratio

15

Extract of BALANCE SHEET OF M/s HPCL Ltd as at 31-Mar-2009

Rs. Rs. Fixed Assets (Net Block) 30,000 Debtors 50,000 Cash at Bank 10,000 Stock 60,000 Total Current Assets (CA) 1,20,000 Creditors 50,000 Total Current Liabilities (CL) 50,000 Working Capital (CA-CL) 70,000 Total Assets 1,00,000 Find Quick Ratio

Illustration 2 – Quick Ratio 16

Current Liabilities

Sundry Creditors 50,000

Quick Ratio = Quick Assets / Current Liabilities

Quick Ratio 1.20

Quick Assets

Debtors 50,000

Cash and Bank 10,000

60,000

Cash ratio

17

Cash Ratio

Also known as “Absolute Liquidity Ratio”

It eliminates any unknowns surrounding receivables.

Formulae – (Cash and Marketable securities) / Current liabilities

Cash Ratio tests only the short term liquidity in terms of cash and marketable securities

18

Illustration 3 – Cash Ratio

19

Extract of BALANCE SHEET OF M/s HPCL Ltd as at 31-Mar-2009

Rs. Rs. Fixed Assets (Net Block) 30,000 Debtors 50,000 Cash at Bank 10,000 Stock 60,000 Total Current Assets (CA) 1,20,000 Creditors 50,000 Total Current Liabilities (CL) 50,000 Working Capital (CA-CL) 70,000 Total Assets 1,00,000 Find Cash Ratio

Illustration 3 – Cash Ratio 20

Cash Ratio = Cash and Marketable Securities / Current Liabilities

Cash Ratio 0.20

Current Liabilities

Sundry Creditors 50,000

Cash

Cash at Bank 10,000

Basic Defense Interval

21

Basic Defense Interval

Helps to determine the number of days the company can cover its cash expenses without the aid of additional financing

Formulae – (Cash + Marketable securities + Receivables) / Cash Expenses per day

Cash Expenses per day – (Operating expenses + Interest + Income Taxes) / 365

22

Net Working Capital

23

Net Working Capital

1

• Banks look at Net Working Capital over time to ascertain the firm’s ability to overcome the financial crisis.

2

• Formulae – • Current Assets – Current Liabilities

(excluding short term bank borrowing)

3

• The results of this calculation must be a positive number. Loans are often tied to minimum working capital requirements

24

Testing time

25

Liquidity Ratios - Multiple Choice Questions

26

MCQ – 1

Quick ratio also known as –

A. Absolute liquidity ratio

C. Cash Ratio

B. Acid Test Ratio

D. None of the above

Answer: B. Acid Test Ratio

27

MCQ – 2

Quick assets =

A. Current assets – Inventories – Prepaid expenses

C. Current assets + Inventories + Prepaid expenses

B. Current assets – Inventories

D. Current assets + Inventories

Answer : A. Current assets – Inventories – Prepaid expenses

28

MCQ – 3

Cash Ratio also known as –

A. Acid Test Ratio

C. Absolute Liquidity Ratio

B. Coverage Ratio

D. None of the above

Answer : C. Absolute Liquidity Ratio

29

MCQ – 4 The ratio that helps in determining the number of days the company can cover its cash expenses without the aid of additional financing is called as –

A. Current Ratio

C. Cash Ratio

B. Basic Defense Interval

D. Quick Ratio

Answer : B. Basic Defense Interval

30

MCQ – 5

Working Capital =

A. Current Assets – Quick Liabilities

C. Current Assets – Current Liabilities

B. Quick Assets – Quick Liabilities

D. Quick Assets – Current Liabilities

Answer : C. Current Assets – Current Liabilities

31

MCQ – 6

Which ratio is the best known measure of financial strength –

A. Acid Test Ratio

C. Current Ratio

B. Cash Ratio

D. None of the above

Answer : C. Current Ratio

32

MCQ – 7

Current Ratio =

A. Current Assets / Quick Liabilities

C. Current Assets / Current Liabilities

B. Quick Assets / Quick Liabilities

D. Quick Assets / Current Liabilities

Answer : C. Current Assets / Current Liabilities

Lesson Summary

33

We had detailed discussions on Current Ratio, Quick Ratio, Cash Ratio, Basic Defense Interval and Net

Working Capital

We have learnt the meaning and purpose of Liquidity ratios

What Next ……

34

Follow the below Presentations

Ratio Analysis Part 1 – Ratio Analysis Overview

Ratio Analysis Part 3 – Leverage Ratios

Ratio Analysis Part 4 - Activity Ratios

Ratio Analysis Part 5 - Profitability Ratios

35

Thank You

36