Ratio Analysis Part 2 Liquidity Ratios Paper 3B: Financial Management Chapter 3 Unit I
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1 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
2 2 Learning Objectives 1. Gain Knowledge on Liquidity Ratios 2. Usage of various Liquidity Ratios 3. Preparation of various Liquidity Ratios
3 3 Introduction to Liquidity Ratios Background Types of Liquidity Ratios
4 4
5 5 Liquidity Ratio - Background Liquidity and Short term solvency Meaning of Liquidity Impact of inability to pay short term liabilities
6 6 Types of Liquidity Ratios Current Ratio Quick Ratio Cash Ratio / Absolute Liquidity Ratio Basic Defense Interval Net Working Capital Ratio
7 Current ratio 7
8 8 Current Ratio 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 Formulae - Current assets / Current liabilities Acceptable current ratio is 2 to 1. A ratio of less than 1 is a cause of concern, particularly if it persists for long time
9 9 Current Assets & Current Liabilities Current Assets Inventories + Receivables + Cash and Bank Balances + Loans and Advances +Disposable investments + Accruals Current Liabilities Creditors for goods and services + Short Term Loans + Bank Overdraft + Cash Credit + Outstanding expenses + Provision for Taxation + proposed Dividend + Unclaimed Dividend
10 10 Illustration 1 Current Ratio 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
11 11 Illustration 1 Current Ratio Current Assets Debtors 50,000 Cash at Bank 10,000 Stock 60,000 1,20,000 Current Liabilities Creditors 50,000 Current Ratio = Current Assets / Current Liabilities Current Ratio 2.40
12 Quick ratio 12
13 13 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
14 14 Quick Assets & Current Liabilities Quick Assets Receivables + Cash and Bank Balances + Loans and Advances +Disposable investments + Accruals Current Liabilities Creditors for goods and services + Short Term Loans + Bank Overdraft + Cash Credit + Outstanding expenses + Provision for Taxation + proposed Dividend + Unclaimed Dividend
15 15 Illustration 2 Quick Ratio 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
16 16 Illustration 2 Quick Ratio Quick Assets Debtors 50,000 Cash and Bank 10,000 60,000 Current Liabilities Sundry Creditors 50,000 Quick Ratio = Quick Assets / Current Liabilities Quick Ratio 1.20
17 Cash ratio 17
18 Cash Ratio 18 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
19 19 Illustration 3 Cash Ratio 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
20 20 Illustration 3 Cash Ratio Cash Cash at Bank 10,000 Current Liabilities Sundry Creditors 50,000 Cash Ratio = Cash and Marketable Securities / Current Liabilities Cash Ratio 0.20
21 Basic Defense Interval 21
22 Basic Defense Interval 22 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
23 Net Working Capital 23
24 24 Net Working Capital Banks look at Net Working Capital over time to ascertain the firm s ability to overcome the financial crisis. Formulae Current Assets Current Liabilities (excluding short term bank borrowing) The results of this calculation must be a positive number. Loans are often tied to minimum working capital requirements
25 25 Testing time Liquidity Ratios - Multiple Choice Questions
26 26 MCQ 1 Quick ratio also known as A. Absolute liquidity ratio B. Acid Test Ratio C. Cash Ratio D. None of the above Answer: B. Acid Test Ratio
27 27 MCQ 2 Quick assets = A. Current assets Inventories Prepaid expenses B. Current assets Inventories C. Current assets + Inventories + Prepaid expenses D. Current assets + Inventories Answer : A. Current assets Inventories Prepaid expenses
28 28 MCQ 3 Cash Ratio also known as A. Acid Test Ratio B. Coverage Ratio C. Absolute Liquidity Ratio D. None of the above Answer : C. Absolute Liquidity Ratio
29 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 B. Basic Defense Interval C. Cash Ratio D. Quick Ratio Answer : B. Basic Defense Interval
30 30 MCQ 5 Working Capital = A. Current Assets Quick Liabilities B. Quick Assets Quick Liabilities C. Current Assets Current Liabilities D. Quick Assets Current Liabilities Answer : C. Current Assets Current Liabilities
31 31 MCQ 6 Which ratio is the best known measure of financial strength A. Acid Test Ratio B. Cash Ratio C. Current Ratio D. None of the above Answer : C. Current Ratio
32 32 MCQ 7 Current Ratio = A. Current Assets / Quick Liabilities B. Quick Assets / Quick Liabilities C. Current Assets / Current Liabilities D. Quick Assets / Current Liabilities Answer : C. Current Assets / Current Liabilities
33 33 Lesson Summary We have learnt the meaning and purpose of Liquidity ratios We had detailed discussions on Current Ratio, Quick Ratio, Cash Ratio, Basic Defense Interval and Net Working Capital
34 What Next 34
35 35 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
36 Thank You 36
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