Introduction to Ratios
Ratio analysis is one of the oldest methods of financial statements analysis. It was developed by banks and other lenders to help them chose amongst competing companies asking for their credit. Two sets of financial statements can be difficult to compare. The effect of time, of being in different industries and having different styles of conducting business can make it almost impossible to come up with a conclusion as to which company is a better investment. Ratio analysis helps creditors solve these issues.
Ratio analysis is very important segment in accounting and finance, also it can show in what kind financial state is company.
In this blog I will elaborate few most important ratios for SME companies the Liquidity Ratios!
1. What are Financial Ratios ?
Financial ratios provide a sort of heuristic or thumb rule that investors can apply to understand the true financial position of a company. There are recommended values that specific ratios must fall within. Whereas in other cases, the values for comparison are derived from other companies or the same companies own previous records. However, instead of undertaking a complete tedious analysis, financial ratios helps investors shortlist companies that meet their criteria.
Investors have limited data to make their decisions with. They do not know what the state of affairs of the company truly is. The financial statements provide the window for them to look at the internal operations of the company. Financial ratios make financial analysis simpler. They also help investors compare the relationships between various income statement and balance sheet items, providing them with a sneak peek of what truly is happening behind the scenes in the company.
Liquidity can be defined as the ability of a firm to make good its short term obligations. Most businesses function on credit. Hence to run a business firms have to both extend credit as well as ensure that they receive credit as well. Liquidity ratios measure the relationship between the amounts of short term capital that the firm has locked in its receivables versus the short term interest free debt it has acquired in the form of accounts payables. Liquidity ratios can be defined as the ratios which help analysts predict the short term solvency of the firm. Short term here is meant to be considered the period until the next business cycle which is usually 12 months.
Liquidity is the Life of a Business! A firm seldom has all the resources it needs to run the business. It gets credit from its employees, suppliers, customers, the government and such other entities. Each of these entities extends credit to the firm on the assumption that it will make good its obligations when they are due. Such obligations are usually due in the short term. Investors are therefore very cautious about ascertaining whether the firm does in fact have the capability to meet these obligations. Liquidity ratios help in ascertaining this. With secondary data that is available in the annual reports of the company, analysts often make projections about whether the company has enough resources to survive the short run without hampering its reputation or operations.
The Current Ratio
The current ratio is the most popularly used metric to gauge the short term solvency of a company. This article provides the details about this ratio.
Formula-Current Ratio = Current Assets / Current Liabilities
Current ratio measures the current assets of the company in comparison to its current liabilities. This means that the firm expects to collect cash from the people that owe it money and pay to the ones that they owe money to on time. Hence if the current ratio is 1.2:1, then for every 1 dollar that the firm owes its creditors, it is owed 1.2 by its debtors.
The ideal current ratio is 2 meaning that for every 1 dollar in current liabilities, the company must have 2 in current assets. However, this varies widely based on the industry in which the company is functioning.
The current ratio makes two very important assumptions. They are as follows:
· The current ratio assumes that the inventory that the company has on hand will be liquidated at the price at which it is present on the balance sheet. However, this may not be the case. Many times inventories become obsolete and have to either be discarded on sold off at a fraction of the cost that they were purchased for. The current ratio does not warn the investors about these risks.
· The current ratio assumes that the debtors of the firm will pay it on time. There is nothing wrong with this belief if it is founded based on strong facts. The analyst must look at the past performance of the firm in collecting its receivables and factor in the late payments and bad debt charges to make the calculation more meaningful.
A moderately high current ratio is considered safe and healthy. However, if the current ratio is too high, it means that company is not effectively managing its current assets. Common symptoms include a lot of obsolete inventory as well as trouble getting paid on time by the debtors.
A current ratio shows the company’s liabilities and assets position for the next 12 months. It is possible that the liabilities may be due in the next 6 months whereas the assets may be due for realization only after 9 months. The current ratio does not provide conclusive information about the liquidity position of the company. Since receivables are included in the calculation, an analyst must also be aware about the age of these receivables. Older receivables are less likely to be collected and therefore investors must be careful about making predictions based on these receivables.
Liquidity has an Impact on Long Term Survival of the Firm, Amateur investors think liquidity is primarily short term. It does not matter whether or not the company can pay its immediate bills, if the long term prospects of the company look good, it is a good investment. This is the farthest from the truth as history has shown liquidity issues can have far reaching effects on the health of a firm sometimes even endangering the very survival of the firm. Here is how it happens:
- Banks Ask For Higher Interest Payments
- Suppliers Are Wary Of Extending Credit
- ·Attracting And Retaining Best Employees May Be As Issue
The quick ratio is a variation of the current ratio. However, a quick ratio is considered by many to be a more conservative estimate than the current ratio. This characteristic fetches it the nickname of being the “Acid test ratio”.
The difference between the current ratio and the quick ratio is the fact that quick ratio excludes the inventory. In theory this may seem like a small difference, however in practice anyone who is aware about the difficulties involved in liquidating inventories at the right price will vouch for the conservativeness of this ratio. The quick ratio has been discussed in greater detail in this article.
Formula-Quick Ratio = (Current Assets – Inventories) / Current Liabilities
The quick ratio checks the company’s performance to fulfill its obligations in a situation when it is not able to liquidate its inventory. In such a situation the company will have to pay its current liabilities out of the cash and cash equivalents that it has on hand and the amount of money it has already tied up in accounts receivables. The ideal quick ratio is considered to be 1:1. However, this varies widely according to the different credit cycles prevalent if different industries. Hence an analyst must look at competing firms and the industry average before forming opinions based on the current ratio.
There are no assumptions made regarding the inventory, because it is excluded from the calculation of this ratio. However, there are assumptions made about debtors and the fact that they will pay up on time to finance the payment of short term liabilities that a company has on hand.
The quick ratio of the company can become unreasonably higher because of a large amount of accounts receivables that the company may have on hand. The true measure of the liquidity management of a company is its ability to complete the cash to cash cycle in the fastest possible time. However if the company has a track record of being able to recover its dues on time large receivable may be overlooked
The Cash ratio
The cash ratio is limited in its usefulness to investors and financial analysts. It is the least popular of the liquidity ratios and is used only when the company under question is under absolute duress. Only in desperate circumstances do situations arise where the company is not able to meet its short term obligations by liquidating its inventory and receivables and this is when the cash ratio comes handy.
Formula-Cash Ratio = (Cash + Cash Equivalents + Marketable Securities) / Current Liabilities
The cash ratio indicates the amount of cash that the company has on hand to meet its current liabilities. A cash ratio of 0.2 would mean that for every rupee the company owes creditors in the next 12 months it has 0.2 in cash. 0.2 is considered to be the ideal cash ratio.
The cash ratio is the most stringent of all liquidity ratios. Hence there are no assumptions made. The cash and cash equivalent figures stated on the balance sheet are facts and so are the current liabilities stated on the balance sheet. Hence there is no assumption about future events that need to occur as per the company’s plan.
The nearest the cash ratio gets to an assumption is that it believes that marketable securities and cash equivalents can be quickly liquidated. Under normal circumstances this is always the case. The only case where liquidation of these securities would be an issue would be the complete failure of the economic system.
A high cash ratio may not be a good thing for a company. Cash is an idle asset. It does not earn a sufficient rate of return. Therefore companies must constantly work towards keeping the cash locked up in gainfully employed investments. A large amount of cash on the balance sheet may be an indicator that the company is running out of investment opportunities.
Wild fluctuations in the cash ratio may not be such a bad thing either. It is not uncommon for companies to keep accumulating cash and then using it at one go when a profitable opportunity arises. It is this nature of the cash ratio that makes its usefulness limited. The cash ratio usually creates more questions than it answers for the financial analysts. Given the fact that analyst may not access to inside information to answer these questions, the usefulness of these ratios remain limited.
Moreover, cash received is not necessarily cash earned. The cash can be in the form of payments received in advance. Moreover, third parties may have the right to demand the payment of that cash. These rights do not appear on the balance sheet in the current liabilities but are present in the footnotes and hence are not used in the calculation of the ratio.
Surce: Accounting for non-accouting students 9 th edition, by John R. Dyson