Financial Ratios

The financial statements of Horizon Limited are given in Exhibits. If you want to compare the financial statements of Horizon Limited with those of other companies, you would have a problem because of differences in size. One way of avoiding this problem is to calculate and compare financial ratios – remember a ratio eliminates the size problem as the size effectively divides out.

A ratio is an arithmetical relationship between two figures. Financial ratio analysis is a study of ratios between various items or groups of items in financial statements. Financial ratios have been classified in several ways. For our purposes, we divide them into five broad categories as follows:

1) Liquidity ratios
2) Leverage ratios
3) Turnover ratios
4) Profitability ratios
5) Valuation ratios

To facilitate, the discussion of various ratios, the financial statement of Horizon Limited shown in Exhibits

Liquidity Ratios:

Liquidity refers to the ability of a firm to meet its obligation in the short run, usually one year. Liquidity ratios are generally based on the relationship between current assets (the sources for meeting short term obligations) and current liabilities. The important liquidity ratios are: current ratio, acid test ratio, and cash ratio.

Current ratio: A very popular ratio, the current ratio is defined as:

Current assets / Current liabilities

Current assets include cash, current investments, debtors, inventories (stocks), loans and advances, and pre-paid expenses. Current liabilities represent liabilities that are expected to mature in the next twelve months. These comprise (1) loans, secured or unsecured, that are due in the next twelve months and (2) current liabilities and provisions.

Horizon’s current ratio for 20X1 is 237 / 180 = 1.32.

The current ratio measures the ability of the firm to meet its current liabilities – current assets get converted into cash during the operating cycle of the firm and provide the funds needed to pay current liabilities. Apparently, the higher the current ratio, the greater the short term solvency. However, in interpreting the current ratio the composition of current assets must not be overlooked. A form with a high proportion of current assets in the form of cash and debtors is more liquid than one with a high proportion of current assets in the form of inventories even though both the firms have the same current ratio.

The general norm for current ratio in India is 1.33. Internationally it is 2.

Acid test ratio: Also called the quick ratio, the acid test ratio is defined as:

Quick assets / Current liabilities

Quick assets are defined as current assets excluding inventories.

Horizon’s acid test ratio for 20X1 is:

(237 – 105) / 180 = 0.73

The acid test ratio is a fairly stringent measure of liquidity. It is based on those current assets which are highly liquid – inventories are excluded from the numerator of this ratio because inventories are deemed to be the least liquid component of current assets.

Cash ratios: because cash and bank balances and short term marketable securities are the most liquid assets of a firm, financial analysts look at cash ratio, which is defined as:

Cash ratio = Cash and bank balances + Current investments / Current liabilities

Horizon’s cash ratio for 20X1 is:

(10 + 3) / 180 = 0.07

Clearly, the cash ratio is perhaps the most stringent measure of liquidity. Indeed, one can argue that it is overly stringent. Lack of immediate cash may not matter if the firm can stretch its payment or borrow money at short notice. Aren’t financial managers quite skillful at these things?

Leverage ratios: Financial leverage refers to the use of debt finance. While debt capital is a cheaper source of finance, it is also a riskier source of finance. Leverage ratios help in assessing the risk arising from the use of debt capital. Two types of ratios are commonly used to analyze financial leverage; structural ratios and coverage ratios. Structural ratios are based on the proportions of debt and equity in the financial structure of the firm. The important structural ratios are: debt equity ratio and debt assets ratio. Coverage ratios show the relationship between debt servicing commitments and the sources for meeting these burdens. The important coverage ratios are: interest coverage ratio, fixed charges coverage ratio, and debt service coverage ratio.