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Financial Ratios with Explanation - Part 1

Published on Monday, December 15, 2014
Today we’re starting a series of articles on ‘Financial Ratios’; very important from interview point of view!

‘Financial Ratios’ refers to a group of different ‘ratios’ which act as a tool to bring out useful information from the elements of a Balance Sheet.

These ratios are nothing but the normal ratios we learnt – except they represent certain items of Balance Sheet/ Profit & Loss Account of a company to present the ‘financial condition’ and other information, which will help stakeholders to make informed decisions.

Financial Ratios in addition to showing a company’s performance/ financial position also helps in comparing two or more companies in financial terms – thus as an investor you’ll know which company to put your funds in! But of course that is not the only use of Financial Ratios.

Financial Ratios are typically classified into four categories:
  1. Liquidity Ratios – show a firm’s ability to meet its short term liabilities, i.e., current obligations.
  2. Profitability Ratios – measures profitability of a firm; measures expenses and income.
  3. Leverage Ratios – essentially measures a firm’s capital structure and its various elements.
  4. Turnover Ratios – income and expense related; sales and expenditure related.
We will discuss every one of the above ratios in ‘brief – detailed’ manner so that we know the basics and something more for our interviews!

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There are 4 Liquidity Ratios:

Current Ratio: 

also simply known as ‘liquidity ratio’ is the ratio between ‘Current Assets’ and ‘Current Liabilities’.
    • The formula is = Current Assets/ Current Liabilities
    • Current Assets include all those assets which are held for a short time in the course of business and which can be easily converted into cash.
    • Examples of Current Assets are: Cash, Bank Balance, Short Term investments, Stock in Trade, Finished Goods, Raw Materials, Prepaid Expenses, Debtors, Bills Receivables etc. As you can see – these items are Cash and Cash Equivalents, i.e., easily convertible into cash.
    • Current Liabilities are obligations of a company which need to met in a short period of time – bills payables, creditors, bank overdraft account etc.
    • Thus Current Ratio – shows the ability of a company to meet its short term or current payment obligations.
    • An ideal current ratio for banks is 1.33:1. Current Assets to be 1.33 times of current liabilities to be in comfortable position and not have excessive current asset sitting idle!

    Acid Test Ratio: also known as Quick Ratio

    • It is also a measure of Current Assets and Current Liabilities – but in this case, the Current Assets include strictly only cash and cash equivalents.
    • Thus Current Assets in Acid Test Ratio includes all current assets except Stock in Trade and Prepaid Expenses – it is also known as Quick Assets – as they can be quickly converted to cash.
    • Stock takes some time to be converted to cash and pre-paid expenses can not be converted into cash – it can only result in receipt of some kind of service in future, hence they are excluded in ‘Quick Assets’
    • Formula is = Quick Assets/ Current Liabilities.
    • Ideal Quick Ratio is 1:1.

    Working Capital Ratio:

    • For any business firm to operate its day to day activities, it need to have cash/funds in hand at all times to carry on its activities without any stoppage or problem – this cash in hand is what in commerce jargon is known as ‘working capital’.
    • Working Capital – ensures smooth operations in terms of availability of funds. Imagine you have to place an order for raw materials and you don’t have money!
    • Thus for any commercial establishment – working capital management is a very important aspect, even for banks; it ensures operational efficiency.
    • Working capital = Current Assets – Current Liabilities.
    • Working Capital Ratio = Current Assets/Current Liabilities.
    • Working capital ratio should always be above 1. If not it means negative working capital, which would mean the payment obligations exceed the funds receipt – which poses problem for a business…obviously!

    Cash Ratio:

    • Is what the name says – the very strict and narrow definition of cash – which includes only cash and cash equivalents, leaving out stock, inventories, debtors, other accounts receivables too.
    • Thus it includes, cash, marketable securities, bank balances only!
    • Thus formula = Cash + Marketable Securities/ Current Liabilities.

    Thus as we see from the above 4 ratios – all deal with Current Assets and Current Liabilities in various ways depending on how narrow or broad they want the definition of the ratios to be.

    This is essence is ‘liquidity’ – a firm’s capability to generate short term funds and pay short term obligations, on regular basis without falling into a funds crisis.

    Thus students of commerce and non-commerce background brush up on basic accounts – these are common interview topics!

    Next up will be profitability ratios.

    Till then keep the interview preps in full swing!

    Good day!

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