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Calculate Current Ratio and Liquid Ratio.

Current ratio = \(\frac {\textit{Current assets}}{\textit{Current liabilities}} \)

=\(\frac{24,00,000}{30,00,000}\) = 0.8 :1

Current Assets = Inventories + Trade Receivables + Cash + Short term Loans and Advances

= 12,00,000+ 9,00,000+ 2,28,000+ 60,000 = Rs. 24,00,000

Current Liabilities = Trade Payables + Short-term Borrowing + Short-term Provisions

= 23,40,000 + 6,00,000 = 60,000 = Rs.30,00,000

2. Quick Ratio

Liquid ratio = \(\frac {\textit{Liquid assets}}{\textit{Current liabilities}} \)

= \(\frac {\textit{12,00,00}}{\textit{30,00,000}} \)= 0.4:1

Quick Assets = Trade Receivables + Cash + Short term Loans and Advances, 

= 9,00,000 + 2,28,000 + 72,000 = Rs. 12,00,000

One ratios reflect both quantitative and qualitative aspects.

False

Current Ratio = \(\frac {\textit{Current Assets}}{\textit{Current Liabilities}} \)

Or, 3.5 = \(\frac {\textit{Current Assets}}{\textit{Current Liabilities}} \)

or, Current Assets = 3.5 Current Liabilities (1)

Working Capital = Current Assets – Current

Liabilities Working Capital = 90,000

or, Current Assets – Current Liabilities = 90,000

or, 3.5 = Current Liabilities – Current Liabilities = 90,000 (from I)

or, 2.5 Current Liabilities = \(\frac{90,000}{2.5}\) = 36,000

or Current Assets = 3.5 Current Liabilities 

= 3.5 × 36,000 = 1,26,000.

Current Ratio = \(\frac {\textit{Current assets}}{\textit{Current Liabilities}} \)

or \(\frac{4.5}{1}\) = \(\frac {\textit{Current assets}}{\textit{Current Liabilities}} \)

or, 4.5 Current Liabilities = Current Assets

Quick Ratio = \(\frac {\textit{Quick assets}}{\textit{Current Liabilities}} \)

or, 3 Current Liabilities = Quick Assets

Quick Assets = Current Assets – Stock

= Current Assets – 36,000

or, 4.5 Current Liabilities – 3 Current Liabilities 

= 36,000

or, 1.5 Current Liabilities = 36,000 or, Current Liabilities 

= 24,000

Current Assets = 4.5 current Liabilities 

or, Current Assets = 4.5 × 24,000 

= 1,08,000.

Current Ratio = \(\frac {\textit{Current assets}}{\textit{Current Liabilities}} \)

or, 4 = \(\frac {\textit{Current assets}}{\textit{75,000}} \)

or, 4 × 75,000 = Current Assets

or, Current Assets = 3,00,000

Liquid Ratio = \(\frac {\textit{Liquid assets}}{\textit{Current Liabilites}} \)

Or, 1 = \(\frac {\textit{Liquid assets}}{\textit{75,000}} \)

Current liabilities

Liquid Assets = 75,000

Stock = Current Assets -Liquid Assets 

= 3,00,000 – 75,000 = 2,25,000

Accounting ratios are classified in two ways Categories as follows 

(i) Traditional Classification: Traditional ratios are those accounting ratios which are based on the Financial Statement like Trading and Profit and Loss Account and Balance Sheet. On the basis of accounts of financial statements, 

The Traditional Classification is further divided into the following categories 

(a) Income Statement Ratios: like Gross Profit Ratio, etc. 

(b) Balance Sheet Ratios: like Current Ratio, Debt Equity Ratio, etc. 

(c) Composite Ratios :like Debtors Turnover Ratio, etc. 

(ii) Functional Classification This classification of ratios is based on the functional need and the purpose for calculating ratio. 

The functional ratios are further divided into the following categories 

(a) Liquidity Ratio: These ratios are calculated to determine short term solvency. 

(b) Solvency Ratio :These ratios are calculated to determine long term solvency. 

(c) Activity Ratio :These ratios are calculated for measuring the operational efficiency and efficacy of the operations. These ratios relate to sales or cost of goods sold. 

(d) Profitability Ratio: These ratios are calculated to assess the

Liquidity ratios are calculated to determine the short-term solvency of a business, i.e. the ability of the business to pay back its current dues. Liquidity means easy conversion of assets into cash without any significant loss and delay. Short-term creditors are interested in ascertaining liquidity ratios for timely payment of their debts. 

Liquidity ratio includes:

Current Ratio: It explains the relationship between current assets and current liabilities. It is calculated as:

Current Ratio = \(\frac {\textit{Current Assets}}{\textit{Current Liabilities}} \)

Liquid Ratio or Quick Ratio: It explains the relationship between liquid assets and current liabilities. It indicates whether a firm has sufficient funds to pay its current liabilities immediately. It is calculated as:

Liquid Ratio = \(\frac {\textit{Liquid Asset}}{\textit{Current Liabilities}} \)

Liquids Assets = Current Assets – Stock – Prepaid Expenses

Profitability ratios are calculated on the basis of profit earned by a business. This ratio gives a percentage measure to assess the financial viability, profitability and operational efficiency of the business. The various important Profitability Ratios are as follows:

Gross Profit Ratio: It shows the relationship between Gross Profit and Net Sales. It depicts the trading efficiency of a business. A higher Gross Profit Ratio implies a better position of a business, whereas a low Gross Profit Ratio implies an inefficient unfavourable sales policy.

Gross profit Ratio = \(\frac {\textit{Gross profit}}{\textit{Net Sales}} \)

Gross Profit = Net Sales – Cost of Goods Sold

Net sales = Total Sales – Sales Return

Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses — Closing Stock

Operating Ratio: It shows the relationship between Cost of Operation and Net Sales. This ratio depicts the operational efficiency of a business. A low Operating Ratio implies higher operational efficiency of the business. A low Operating Ratio is considered better for the business as it enables the business to be left with a greater amount after covering its operation costs to pay for interests and dividends.

Operating Ratio = \(\frac {\textit{Operating Cost}}{\textit{Net Sales}} \times 100\)

Operating Cost = Cost of Goods Sold + Operating Expenses 

Cost of Goods Sold = Sales – Gross Profit

Operating Profit Ratio: It shows the relationship between the Operating Profit and Net Sales. It helps in assessing the operational efficiency and the performance of the business.

Operating Profit Ratio = \(\frac {\textit{Operating Cost}}{\textit{Sales}} \times 100\)

Operating Profit Ratio = 100 – Operating Ratio

Operating Profit = Sales – Operation cost

Net Profit Ratio = \(\frac {\textit{Net Profit}}{\textit{Net Sale}} \times 100\)

or,\(\frac {\textit{Profit Before Tax}}{\textit{Net Sales}} \times 100\)

or,Net profit Ration = \(\frac {\textit{Profit After Tax}}{\textit{Net Sale}} \times 100\)

Net Sales = Total Sales – Sales Return

Return on Investment or Capital Employed: It shows the relationship between the profit earned and the capital employed to earn that profit. It is calculated as:

Return on Investment or Capital Employed = \(\frac {\textit{Profit before interest and Tax}}{\textit{Capital Emplyed}} \times 100\)

Capital Employed = Fixed Assets + Current Assets- Current Liabilities 

Or, 

Capital Employed = Share Capital + Reserve and Surplus + Long-term Funds-Fictitious Assets

Earning per Shares: It shows the relationship between the amount of profit available to distribute as dividend among the equity shareholders and number of equity shares

Earning per share = \(\frac {\textit{Profit available for equity share holders}}{\textit{Number of equity shares}} \)

Profit available for equity shareholers = Net Profit after tax

Dividend payout Ratio: It shows the relationship between the dividend per share and earnings per share. This ratio depicts the amount of earnings that is distributed in the form of dividend among the shareholders. A high Dividend Payout Ratio implies a better position and goodwill of the business for the shareholders.

Dividend payout ration = \(\frac {\textit{Dividend per share}}{\textit{Earning per share}} \)

Dividend per share = \(\frac {\textit{Dividend paid}}{\textit{No.of share}} \)

Price Earnings Ratio: It shows the relationship between the market price of a share and the earnings per share. This ratio is the most common tool that is used in the stock markets. This ratio depicts the degree of reliance and trust that the shareholders have on the business.

price Earning Ratio = \(\frac {\textit{Market Price of a share}}{\textit{Earnings per share}} \).

(c) Lenders and suppliers

The ratio analysis is the most powerful tool of financial statement analysis. Ratios simply mean one number expressed in terms of another. A ratio is a statistical yardstick by means of which relationship between two or various figures can be compared or measured. Ratios can be found out by dividing one number by another number. Ratios show how one number is related to another.

Solvency position of a firm is studied with the help of the Solvency Ratios. Solvency ratios are the measures of the long-term financial position of the firm in terms of its ability to pay its long-term liabilities. In other words, the solvency of the firm is measured by its ability to pay. its long term obligation on the due date. Long term solvency of any business can be calculated on the basis of the following ratios:

Debt-Equity Ratio: It depicts the relationship between the borrowed fund and owner’s funds. The lower the debt-equity ratio higher will be the degree of security to the lenders. A low debt-equity ratio implies that the company can easily meet its long term obligations. Equity or the Shareholders Fund includes. Preference Share Capital, Equity Share Capital, Capital Reserve, Securities Premium, General Reserve less Accumulated Loss and Fictitious Assets

Debt- Equity Ratio = \(\frac {\textit{Long- term Debt}}{\textit{Equity/ Share holders Fund}} \)

Total Assets to Debt Ratio: It shows the relationship between the total assets and the long term loans A high Total Assets to Debt Ratio implies that more assets are financed by the owner’s fund and the company can easily meet its long-term obligations. Total Assets includes all fixed and current assets except fictitious assets like, Preliminary Expenses, Underwriting Commission, etc. Debt includes all long-term loans that are to be repaid after one year. It includes debentures, mortgage loans, bank loans, loans from other financial institutions, etc.

Total Assets to Debt Ratio = \(\frac {\textit{Total Assets}}{\textit{Long-term Debt}} \)

Interest Coverage Ratio: This ratio depicts the relationship between amount of profit utilise for paying interest and amount of interest payable. A high Interest Coverage Ratio implies that the company can easily meet all its interest obligations out of it’s profit.

lnterest Coverage Ratio= \(\frac {\textit{Net profit before interest and tax}}{\textit{Interston long-term Loan}} \)

Proprietary Ratio: It shows the relationship between the Shareholders Fund and the Total Assets. This ratio reveals the financial position of a business. The higher the ratio the higher will be the degree of safety for the creditors, It is calculated as: Proprietary Ratio

Long term creditors are concerned about the ability of a firm to discharge its obligations to pay interest and repay the principal amount of term. 

True

(a) Inventory Turnover Ratio: This ratio is cc puted to determine the efficiency with which the stock is used. This ratio is b; scd on the relationship between cost of goods sold and average stock kept during the year

Inventory/Stock Turnover Ratio = \(\frac {\textit{Cost of good sold}}{\textit{Average stock}}\)

Cost of goods sold = Opening Stock + Purchases + Direct expenses – Closing Stock 

Or cos to goods sold = Net sales – Gross Profit

Average Stock = \(\frac {\textit{opeing stock+Closing stock}}{\textit{2}}\)

(b) Debtors Turnover Ratio: This ratio is computed to determine the rate at which the amount is collected from the debtors. It establishes the relationship between net credit sales and average accounts receivables,

Debtors Turnover Ratio = \(\frac {\textit{Net Credit sales}}{\textit{Average Acounts Receivables}}\)

Net Credit Sales = Total Sales – Cash Sales 

Average Account Receivables 

=\(\frac {\textit{(Opening Debtors+Opening B/R)+(Closing Debtors +Closing B/R)}}{\textit{2}}\)

(c) Payable Turnover Ratio: This ratio is known as Creditors Turnover Ratio.’ It is computed to determine the rate at which the amount is paid to the creditors. It establishes the relationship between net credit purchases and average accounts payables.

Payable Turnover Ratio = \(\frac {\textit{Net Credit sales}}{\textit{Average Account Paybles}}\)

Net Credit purchases = Total Purchases – Cash Purchases Average Account Payable

\(\frac {\textit{(Opening Creditors+Opening B/R)+(Closing Creditors +Closing B/R)}}{\textit{2}}\)

(d) Working Capital Turnover Ratio: This ratio is computed to determine how efficiently the working capital is utilised in making sales. It establishes the relationship between net sales and working capital.

Working Capital Turnover Ratio =\(\frac {\textit{Net sales}}{\textit{Working Captal}}\)

Net Sales = total Sales – Sales Return Working Capital 

= Current Assets – Current Liabilities.

The liquidity of a business firm is measured by its ability to pay its long term obligations, Die long term obligations include payments of principal amount on the due date and payments of interests on the regular basis. Long term solvency of any business can be calculated on the basis of the following ratios:

Debt-Equity Ratio: It depicts the relationship between the borrowed fund and owner’s funds. The lower the debt-equity ratio higher will be the degree of security to the lenders. A low debt-equity ratio implies that the company can easily meet its’long term obligations.

Debt-Equity Ratio = \(\frac {\textit{Long - term Debt}}{\textit{Equity/ Share holders Fund}}\)

Total Assets to Debt Ratio: It shows the relationship between the total assets and the long term loans A high Total Assets to Debt Ratio implies that more assets are financed by the owner’s fund and the company can easily meet its long-term obligations.

Total Assets to Debt Ratio = \(\frac {\textit{Total Assets}}{\textit{Long-term Debt}}\)

Interest Coverage Ratio: This ratio depicts the relationship between amount of profit utilise for paying interest and amount of interest payable. A high Interest Coverage Ratio implies that the company can easily meet all its interest obligations out of its profit.

Interest Coverage Ratio = \(\frac {\textit{Net profit before Interest and Tax}}{\textit{Interest on long-term Loans}}\)

Proprietary Ratio: It shows the relationship between the Shareholders Fund and the Total Assets. This ratio reveals the financial position of a business. The higher the ratio the higher will be the degree of safety for.the creditors. It is calculated as:

Proprietary Ratio= \(\frac {\textit{Share holders Fund}}{\textit{Total Assets}}\) or \(\frac {\textit{Equity}}{\textit{Total Assets}}\)

Nature of business make inventory turnover ratio more important in case of a grocery store as compare to an insurance company. A grocery store is a trading concern involved in trading i.e., buying and selling of goods and in this regards it is obvious to maintain some inventory in stores. On the other hand, insurance company involved in service business and involved in delivering service there is no question of inventory because service is perishable in nature and cannot be stored. That’s why inventory turnover ratio is more important in case of grocery store than an insurance company.

Financial ratios help their users to take various managerial decisions. In this context there are four categories of users who are interested in financial ratios. These are the management, investors, long term creditors and short term creditors. 

The significance of ratios to the above mentioned users is as follows 

(i) Management :Management calculate ratios for taking various managerial decisions. Management is always interested in future growth of the organisation. In this regard management design various policy measures and draft future plans. Management wish to know how effectively the resources are being utilised conseguently, they are interested in Activity Ratios and Profitability Ratios like Net Profit Ratio, Debtors Turnover Ratio, Fixed Assets Turnover Ratios, etc. 

(ii) Equity Investors :The prime concern of investors before investing in shares is to ensure the security of their principle and return on investment. It is a well known fact that the security of the funds is directly related to the profitability and operational efficiency of the business. In this way they are interested in knowing Earnings per Share, Return on Investment and Return on Equity. 

(iii) Long Term Creditors: Long term creditors are those creditors who provide funds for more than one year, so they are interested in long term solvency of the firm and in assessing the ability of the firm to pay interest on time. In this way they are interested in calculating Long term Solvency Ratios like, Debt-Equity Ratio, Proprietory Ratio, Total Assets to Debt Ratio, Interest Coverage Ratio, etc. 

(iv) Short Term Creditors :Short term creditors are those creditors who provide financial assistance through short term credit (Generally less than one year). That’s why short-term creditors are interested in timely payment of their debts in short run. In this way they are always interested in Liquidity Ratios like, Current Ratio, Quick Ratios etc. These ratios reveal the current financial position of the business. It is always observed that short term obligations are paid through current assest.

Grocery store is a trading concern and involved in business of buying and selling of grocery. It keeps stock of various groceries to meet the requirement of the customers and it should calculate the inventory turnover ratio. Hence, this ratio is more important for a grocery store then it is for an insurance company as the latter does not need to maintain any stock of goods sold. The insurance company is engaged in delivering service that is intangible and, thus, cannot be stored.

(b) Inventory turnover

(c) Average collection period

The above mentioned statement is true. There are two different ways to measure the liquidity of a firm first through current ratio of the firm and second through quick ratio of the firm. The second one is considered the more refine form of measuring the liquidity of the firm. The current ratio ‘explains the relationship between current assets and current liabilities. If current assets are quite capable to pay the current liability the liquidity of the concerned firm will be considered good. But here generally one question arises there are certain assets which cannot be converted into cash quickly such as stock and prepaid expenses. As far as the matter of prepaid expenses is concerned it’s ok but what about the stock if we measure the liquidity on the basis of conversion of current assets in cash there are many firms where conversion of stock is not possible into cash frequently say e.g., heavy machinery manufacturing companies, locomotive companies, etc. This is because, the heavy stocks like machinery, heavy tools etc. cannot be easily sold off. In this case it is always advisable to follow the current ratio for measuring the liquidity of a firm.

But on the other hand, in case of those firms where the stock can be easily realised or sold off consideration of stock should be avoided and to measure the liquidity of that firm Quick ratio should be calculated, e.g., the inventories of a service sector company are very liquid as there are no stocks kept for sale, so in that case liquid ratio must be followed for measuring the liquidity of the firm. 

We can understand from the above mentioned statement in the light of another example where stock contribute the major portion in current assets in that case to find out the liquidity of that firm stock cannot be avoided to measure the liquidity of the firm. On the other hand where stock contributes a reasonably less amount it can be avoided and liquidity of that firm can be measured with the help of quick ratio. On the other hand where there is a lot of fluctuation in the price of stock it is always advisable to compute quick ratio and avoid the stock figure because it will reduce the authenticity of liquidity measure.

Current Ratio: It explains the relationship between current assets and current liabilities. It is calculated as:

Current Ratio = \(\frac {\textit{Current Assets}}{\textit{Current Liabilities}} \)

Currents Assets are those assets that are easily converted into cash within a short period of time like cash in hand, cash at bank, marketable securities, debtors, stock, bills receivables, prepaid expenses, etc.

Current Liabilities are those liabilities that are to be repaid within a year like bank overdraft, bills payables, Short-term creditors, provision for tax, outstanding expenses etc:

Liquid Ratio: It explains the relationship between liquid assets and current liabilities. It indicates whether a firm has sufficient funds to pay its current liabilities immediately. It is calculated as:

Liquid Ratio = \(\frac {\textit{Liquid Assets}}{\textit{Current Liabilities}} \)

Liquid Assets = Current Assets – Stock – Prepaid Expenses

Generally, Current Ratio is preferable for such type of business where the stock or the inventories cannot easily be converted into cash like heavy machinery manufacturing companies, locomotive companies, etc. This is because, the heavy stocks like machinery, Heavy tools etc. cannot be easily sold off. But on the other hand, the businesses where the stock can be easily realised or sold off regard Liquid Ratio to be more suitable measure to reveal their liquidity position. For example, the inventories of a service sector company are very liquid as there is no stock kept for sale, so they prefer Liquid Ratio as a measure of overall liquidity.

Moreover, sometimes companies prefer to resort to Liquid Ratio instead of Current Ratio, if the prices of the stock held are prone to fluctuate. This is because if the prices of the inventories fluctuate more, then this may affect their liquidity position of the business and may reduce (or overcast) the Current Ratio. Consequently, they prefer Liquid Ratio as it excludes inventories and stocks.

Thirdly, if the stock forms the major portion of a company’s current assets, then they would prefer Current Ratio and not Liquid Ratio. This is because their current assets mostly consist of stock. The Liquid Ratio of such company will be very low as liquid assets exclude stock. This will reduce their Liquid Ratio and may create a bad image’for the creditors. In such a case, Current Ratio provides better measure of overall-liquidity.

(d) Liquid ratio, inventory

The only purpose of financial reporting is to keep the managers informed about the progress of operations. 

False