27 Classification, Computation & Interpretation of Liquidity and Turnover Ratios
Deepika Gautam
LEARNING OBJECTIVES:
The student may able to learn various liquidity and efficiency ratios because these ratios helps in decision making and comment upon the short- term paying capacity of a concern or the firm’s ability to meet its current obligations. The various liquidity ratios are; current ratio, liquid ratio and absolute ratio. Further this module will help to understand the efficiency with which the liquid resources have been employed by a firm because turnover ratios indicate the speed with which assets are being turned over into sales.
CLASSIFICATION OF RATIOS
Traditional (These types include balance Sheet Ratios, Profit & Loss Account Ratios and inter Statement Ratios):
(i) Balance Sheet ratios deal with the relationship between two balance sheet items.
(ii) Profit & Loss Account ratios deals with the relationship between two profits and loss account items.
(iii) Inter statement ratios exhibit the relationship between profit & loss account and balance sheet item.
- Functional or According to Tests (According to the tests satisfied, various ratios classified are Liquidity, Long Term Solvency, leverage Ratios, Activity ratios and Profitability Ratios)
- (i) Liquidity ratio measure the ability of the enterprise to pay its debts as they mature.
- (ii) Long term solvency and leverage ratios convey a firm’s ability to meet the interest costs and repayments schedules of its long term obligations.
- (iii) Activity ratios measure the efficiency with which the resources of a firm have been employed.
- (iv) Profitability ratio Measure management’s success in generating returns for those who provide capital to the enterprise.
- Significance or According to Importance (Some ratios are more important than other and firm may classify them as primary and secondary ratios. The British Institute of management has recommended the classification of such ratios). For inter-firm comparisons, the ratios may be classified as Primary ratios and Secondary ratios. The primary ratio is one which is of prime importance to a concern; thus return on capital employed is named as primary ratio. The other ratios which support or explain the primary ratio are called secondary ratios.
Liquidity Ratios:
To measure, the short term solvency of firm or financial position of a firm liquidity ratios are applied. These ratios measure the liquidity (cash position) of the firm in the absence of which the firm may become insolvent. These ratios are calculated to comment upon the short-term paying capacity of a concern or the firm’s ability to meet its current obligations. The current assets should either be liquid or near liquidity. These should be convertible into cash for paying obligations of short-term nature. The categories in which liquidity ratios can be classified are as follows:
1. Current ratio
2. Liquid ratio or Quick Ratio
3. Absolute Liquid Ratio
4. Interval Measure or Defensive- Interval ratio
1. CURRENT RATIO:
It may be defined as the relationship between current assets and current liabilities. Current ratio is also known as working capital (The working capital is the amount which is required to meet the day to day expenses of business) ratio, is a measure of general liquidity and is most widely used to make the analysis of a short-term financial position or liquidity of a firm. A current ratio of more than one means that a business has more current assets per rupee of current liabilities, implying that it may be able to pay its current liabilities using its current assets. In other words, its operations will not be disrupted. This assumes that the current assets will fetch at least the stated amounts. It is calculated by dividing the total of current assets by total of the current liabilities. In short, it implies how much cash and cash equivalent is available with the firm for every rupee liability it holds.
Current Ratio = Current Assets
Current Liabilities
The two most basic component of current ratio are: Current Assets and Current Liabilities
Analysis of Current Ratio:
1. A relatively high current ratio is an indication that the firm is liquid and the company has the ability to pay its current liabilities in time as and when they become due.
2. A relatively low current ratio represents that the liquidity position of the firm is not good and the firm shall not be able to pay its current liabilities in time.
3. As a convention the minimum of two to one ratio is referred to as a banker’s rule of thumb or arbitrary standard of liquidity for a firm. A ratio equal or near to the rule of thumb of 2:1 i.e., current assets double the current liabilities is considered to be satisfactory.
FACTORS TO BE CONSIDERED BEFORE CONCLUSION
A number of factors should be taken into consideration before reaching a conclusion about short-term financial position. Some of these are as follows:
(a) Type of business: A business with heavy investments in fixed assets may be successful even if the ratio is low. On the other hand, a trading concern will require a high current ratio because it has to pay its suppliers quickly.
(b) Types of products: A business dealing in goods whose demand changes fast will require a higher current ratio. On the other hand, if products have more intrinsic value, a lower current ratio may also do.
(c) Reputation of the concern: A business unit with better goodwill and reputation may afford a small current ratio because the turnover is more. A new concern which has not established its reputation will need higher current assets to pay current liabilities in time.
(d) Seasonal Influence: In a peak season, current assets will be more and current ratio will be high. On the other hand this ratio will go down when the season is off.
SIGNIFICANCE AND LIMITATIONS OF CURRENT RATIO
Current ratio is a general and quick measure of liquidity of a firm. It represents the margin of safety or cushion available to the creditors and other current liabilities. It is most widely used for short-term analysis of financial position of a firm, but one has to be careful while using current ratio as a measure of liquidity because it suffer from the following limitations:
(a) Crude ratio: Current ratio considers only quantitative aspects of assets and liabilities whereas the quality of current assets and liabilities are totally ignored.
(b) Window Dressing: Window dressing may be indulged in the following ways:
(i) The value of closing stock may be overvalued
(ii) Short-term liability is considered as a long-term liability.
(iii) Cash receipt which is applicable to the next year’s sales recorded in advance
(iv) No provision for bad and doubtful debts.
Weighted Current Ratio:
Under this Weights are assigned, on each individual component of current assets and current liabilities, will depend upon the degree of their relative liquidity in case of current assets and relative urgency of payments in case of current liabilities having due regard, however, in each case upon the nature and types of business.
Weighted Current Ratio = Total Product of Current Assets
Total Product of Current Liabilities
(The weighted current ratio is considered to be the more reliable than the ordinary current ratio as a measure of liquidity)
Illustration1: Current assets of a firm as Rs 2, 50,000 and Current liabilities as Rs 1,00,000; current ratio will be ?
Solution:
Current Ratio = Current Assets
Current Liabilities
Current Ratio= 2,50,000
1,00,000 = 2.5
(The current ratio 2.5 means that current assets are 2.5 times of current liabilities.)
Illustration2: The following information of a company is given:
Current Ratio=2.5:1, Current liabilities Rs 50,000
Find out: Current Assets.
Solution: We all know that
Current Ratio = Current Assets
Current Liabilities
(As given in question, put the values in to formula)
2.5= Current Assets
50,0000
Current assets= 50,000*2.5= 1,25,000
2. LIQUID RATIO OR QUICK RATIO:
All current assets cannot liquid at same time. While cash is readily available to make payments to suppliers and debtors can be converted into cash with some effort, inventories are two steps away from cash. Thus a large current ratio by itself is not a satisfactory measure of liquidity when inventories constitute a major part of the current assets. It is also known as Acid test or liquid Ratio, is a more rigorous test of liquidity than the current ratio. The term liquidity refers to the ability of a firm to pay its short-term obligations as and when they become due.
[High Quick ratio is an indication that the firm is liquid
Low Quick Ratio represents that the firm’s liquidity position is not good]
Points to be considered while applying quick ratio:
(a) Stock is to be excluded as inventories as it cannot be termed to be liquid assets because stock cannot be converted into cash immediately without a sufficient loss of value.
(b) Prepaid expenses are also excluded because they are not expected to be converted into cash.
(c) A rule of thumb or as a convention quick ratio of 1:1 is considered satisfactory.
(d) This ratio is very useful in measuring the liquidity position of a firm.
(e) It measures the firm’s capacity to pay off current obligations immediately.
(f) Quick ratio can be used as a complementary ratio to the current ratio.
Quick Ratio= Quick Assets*
Current Liabilities
*Quick Assets= Current Assets – Stock – Prepaid Expenses
Quick Assets can also be calculated as:
Current Assets- (Inventories + Prepaid Expenses). Inventories here will mean all types of stocks i.e.
finished, work-in-process and raw materials.
Illustration3: With the following extracts calculate Quick Assets:
Quick Ratio: 1.5:1 and Current Liabilities: Rs 50,000
As we know that……
Quick Ratio= Quick Assets
Current Liabilities
Therefore
1.5= Quick Assets
50,000
Quick Assets= 50,000* 1.5 = | Rs75, 000. |
3. ABSOLUTE LIQUID RATIO:
Absolute liquid assets include cash in hand and cash at bank and marketable securities or temporary investments. Although receivables, debtors and bills receivable are generally more liquid than inventories, yet there may be doubt regarding their relationship into cash immediately or in time. The acceptable norm or rule of thumb for this ratio is 50% or 0.5:1 or 1:2.
Therefore
Absolute Liquid Ratio= Absolute Liquid Assets*
Current Liabilities
Absolute Liquid Assets* = Cash & Bank +Short -term Securities
Illustration 4: If Gautam company Ltd’s Bank balance is Rs 45,000, and short term investments are Rs 25,000, current liability are Rs 1,65,000 then what will be absolute liquid ratio?
Solution: | Absolute Liquid Ratio= | 45000+25000 | |
1,65,000 | |||
Absolute Liquid Ratio= | 0.42 |
(The absolute ratio is slightly low because it is 0.42 whereas the accepted standard is 0.5)
4. Interval Measure or Defensive- Interval ratio:
In addition to the comparison of current or liquid assets to current liabilities, the liquidity position of a firm may also be explained to measure whether the liquid assets are sufficient relative to the firm’s daily cash requirements for operating expenses. Such a measure of liquidity is called interval measure ratio which can be calculated as follows:
Interval Measure=
Quick or liquid Assets
Average Daily cash operating expenses
Average Daily Operating Expenses =
Cost of Goods sold+ Adm. & off. Exp.+ Sell. & Dist. Exp. (Less Dep. And other Non- Cash Exp.)
No. of Days in a Year (365 or 360)
Illustration 5: Calculate interval measure from the following information:
Cost of Goods Sold = Rs 40,000
Administrative & office Expenses= Rs 25,000
Depreciation= Rs 8,000
Selling Expenses = Rs 15,000
Liquid Assets- Rs 15,000
Solution:
Interval Measure= Quick or liquid Assets
Average Daily cash operating expenses
Average Daily expenses= | 40,000+ 25,000 + 15,000-8,000 |
360 |
= Rs 200
Interval Measure= 15,000
200
= 75 days
EFFICIENCY RATIOS:
Funds are invested in various assets in business to make sales and earn profits. The efficiency with which assets are managed directly affects the volume of sales. Optimum utilization of available resource is very important in every organization. The better the management of assets, the larger is the amount of sales and the profits. Activity ratios measure the efficiency or effectiveness with which a firm manages its resources or assets. These ratios are also called turnover ratios.
1. Inventory/Stock Turnover Ratio
2. Debtors Turnover Ratio
3. Creditors Turnover Ratio
4. Working Capital Turnover Ratio
1. Inventory Turnover ratio:
It is also known as stock velocity. It is normally calculated as sales/average inventory or cost of goods sold/ average inventory. The figure of inventory at the end of the year should not be taken for calculating stock velocity because normally the stock at the year end is low. Inventory turnover ratio measures the velocity of conversion of stock into sales.
High Inventory turnover ratio indicates= efficient management
Low Inventory turnover ratio indicates= inefficient management
Inventory Turnover Ratio= Cost of Goods Sold
Average Inventory at Cost*
Cost of Goods Sold= Sales- Gross profit
Or
Inventory Turnover Ratio= Net Sales
Average Inventory at Cost*
Average Inventory at Cost* = Opening Stock + Closing Stock
2
Illustration 5: If inventory Turnover Ratio is 5 times and average stock at cost is Rs 75,000, find out cost of goods sold.
Solution: Inventory Turnover Ratio = Cost of Goods Sold
Average Inventory at Cost
5 = Cost of Goods Sold
75,000
Cost of goods sold= 75,000* 5 = 3,75,000
2. DEBTORS TURNOVER RATIO:
To measure the liquidity of specific current assets in order to understand the quality of current assets it is very important to calculate the debtors’ turnover ratio. A company’s ability to collect from its customers in a prompt manner enhances its liquidity. The debtor’s turnover ratio measures the efficacy of a firm’s credit policy and collection mechanism and shows the number of items each year the debtors turn into cash. It indicates the velocity of debt collection of firm. In other words, it indicates the number of times average debtors are turned over during a year, thus:
Debtors Turnover = Net Credit Annual Sales
Average Trade Debtors*
*Average Trade Debtors = Opening Debtors+ Closing Debtors
2
Debtors’ turnover is the ratio of net sales to average debtors. Ideally the numerator should include only net credit sales, but this information is not available in published reports. Therefore, the analyst has no option but to use net sales though it would not include cash sales.
3. CREDITORS TURNOVER RATIO:
In the course of business operations, a firm has to make credit purchase and incur short-term liabilities. Credit turnover ratio indicates the velocity with which the creditors are turned over in relation to purchases. Generally, higher the creditors’ velocity better it is or otherwise lower the creditors’ velocity, less favorable are the results.
Creditors Turnover Ratio = Net Credit Annual Purchases
Average Trade Creditors*
(If information about credit purchases is not available, the figure of total purchases may be taken as the numerator and the trade creditors include sundry creditors and bills payables.) Or
Average payment Period = Trade Creditors * No of Working days
Net Annual purchases
The average payment period ratio represents the average number of days taken by the firm to pay its creditors.
[Lower the Ratio = The better is the liquidity position of the firm
Higher the Ratio = Less the liquidity position of the firm]
4. WORKING CAPITAL TURNOVER RATIO:
It is directly concerned with sales. The working capital is taken as: Working capital = Current Assets- Current Liabilities
This ratio indicates the velocity of the utilization of net working capital. This ratio indicates the number of times the working capital is turned over in the course of a year. Working capital turnover ratio measures the efficiency with which the working capital is being used by the firm.
[Higher ratio indicates efficient utilization of working capital
Lower ratio indicates inefficiency]
This ratio can at best be used by making of comparative and trend analysis for different firms in the same industry and for various periods. This ratio can be calculated as:
Working Capital turnover Ratio= Cost of Sales
Average Working capital*
*Average Working Capital = Opening Working Capital+ Closing Working Capital
2
Illustration 6: Find out working capital turnover ratio:
Cash= 10,000
Bills Receivable= 5,000
Sundry Debtors= 25,000, Sundry creditors= 30,000
Stock = 20,000 and Cost of Sales = 1,50,000
Solution:
As we know that Working capital Turnover ratio = Cost of Sales
Net working Capital
Current assets= 10,000+ 5,000+ 25,000 +20,000 = 60,000
Current liabilities= 30000
Working Capital = 60,000- 30,000 = 30,000
So, Working Capital turnover Ratio= 1,50,000 30,000
= 5 times
SUMMARY:
The current ratio (Current Assets/Current Liabilities) measures the ability of an organization to pay off its debts. Though the ideal current ratio depends to some extent on the type of business, a general rule of thumb is that it should be at least 2:1. The quick ratio is a more rigorous test of liquidity than the current ratio and is used as a complimentary ratio to the current ratio. But both current and quick ratios give misleading results if current assets include high amount of debtors due to slow credit collections. In the same manner, current ratio may be further misleading if the assets include high amount of slow moving inventories. As both these ratios ignore the movement of current assets, it is important to have knowledge of efficiency ratios to comment upon the liquidity. Effective utilization of resources is in the hands of the management, the more effectively a company may utilize its resources the better will be the profitability position of the concern.
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Few Suggested Readings:
- Gupta, K. Shashi (2011), “Financial Management”. New Delhi- 110 002: Kalyani Publishers.
- Grewal’s T.S, Analysis of Financial Statements, Gayatri Enterprises, Noida
- Hawawini Gabriel A, Finances for Executives: managing for value creation/Gabriel Hawawini, Claude Viallet-2nd ed. Thomson Learning, Inc., South-Western.
- Jaiswal. Pawan & Singh. P Nidhi (2007) “Business Finance” Goel Printers Allahabad.
- Palepu, G.Krishna, Healy. M Paul and Victor L. Bernard (2004), Business Analysis & Valuation, Cengage Learning India Pvt. Ltd.
- Sahni, N.K & Gupta Meenu (2011), Financial Management. New Delhi- 110 002: Kalyani Publishers.
Points to Ponder
- The sufficiency or insufficiency of current assets should be assessed by comparing them with short-term liabilities.
- The bankers and suppliers of goods and other short term creditors are interested in the liquidity of the concern.
- Bank overdraft is a current liability because the amount will have to be cleared at the end of every year.
- A firm having a high quick ratio may not have a satisfactory liquidity position if it has slow-paying debtors.
- The level of inventory should neither be too high nor too low.