Liquidity Ratios give the measure of the ability of a firm to meet its current and short term obligations. The higher the ratio the greater is the liquidity and vice versa. But greater liquidity implies that the firm has blocked a greater amount as idle funds which could have been put to better use and generated more returns for the firm. An efficient financial manager seeks to achieve a proper balance between liquidity on one hand and profitability on the other.
The current ratio is the ratio of total current assets to total current liabilities.
Current ratio= Current assets / Current liabilities
Current assets of a firm represent those assets which can be converted into cash within a short period of time, usually not more than one year. This includes cash, bank balances, inventories, debtors, prepaid expenses etc. The current liabilities are the liabilities which are short term maturing obligations to be met, within a year. This includes trade creditors, bills payable, provision for taxation etc.
Acid Test ratio or Quick ratio
The quick asset ratio is the ratio of quick assets to current liabilities.
Quick ratio = Quick assets / Current liabilities
The term quick assets includes those assets which can be converted into cash immediately or at a short notice without diminution of the value.
The current assets which are not considered as quick assets are:
2. Prepaid expenses
This is because the inventory cannot be easily and readily converted into cash. Similarly prepaid expenses are not available to pay off current debts.
In addition to liquidity ratios, turnover ratios also give the measure of the liquidity of a firm, as these indicate how quickly the current assets are converted into cash. The turnover ratios relevant to the liquidity of a firm are:
(1) Inventory turnover ratio (2) Debtors turnover ratio (3) Creditors turn over ratio.
The leverage ratios are also known as capital structure ratios. These ratios give measure of the long term solvency of the firm. As we know short term creditors are interested in liquidity ratios. Similarly, long term creditors are interested in leverage ratios. Leverage ratios indicate the ability of the firm (1) to repay the principal when it becomes due (2) to make regular payments of interest.
There are two types, but mutually interdependent, leverage ratios. First, ratios relating to borrowed funds and owners’ capital. These ratios are computed from the balance sheet.
1. debt equity ratio
2. equity-asset ratio
3. debt-asset ratio
The other type of leverage ratios are coverage ratios. These include (1) Interest coverage ratio (2) Dividend coverage ratio (3) Interest and principal coverage ratio.
Debt equity Ratio
This is the ratio of debt to equity. The debt includes all short term and long term liabilities. Whereas equity includes shareholders capital, preference share capital and past accumulated profits but excludes fictitious assets like past accumulated losses, discount on issue of shares etc.
Debt equity ratio = Debt / Equity
This ratio reflects the relative claims of the creditors and shareholders against the assets of the firm.
Equity assets ratio
Equity asset ratio = Equity / Assets
Equity includes shareholders’ capital, preference share capital and past accumulated profits but excludes fictitious assets like past accumulated losses discount on issue etc. Assets include total assets. This ratio indicates proportion of total assets financed by owners.
Similarly debt asset ratio is the ratio of debt to total assets indicating the proportion of total assets financed by long term debt.
Interest Coverage Ratio
It is the ratio of earnings before interest and tax (EBIT) to the fixed interest charges ion debt capital.
Here we are considering EBIT or operating profit as numerator because interest is tax deductible. Tax liability is calculated after paying interest on the long term loan.
Interest coverage = EBIT / Interest
From the viewpoint of the creditors, the larger the ratio, the greater is the safety and the lesser the risk. However, from the viewpoint of management greater ratio imply unused debt capacity.
Dividend Coverage Ratio
This is the ratio of earnings after tax (PAT) to the amount of preference dividend.
Dividend coverage ratio =
PAT / Preferences dividend