Liquidity ratios help to evaluate the ability of firm to meet its short-term obligations.
Current ratio
Quick ratio
Absolute quick ratio
Working capital ratio
Debtor‟s turnover ratio
Average collection period
Creditors turnover ratio
Average payments period
Inventory turnover ratio Current Ratio
:
Current ratio may be defined as the relationship between current assets and current liabilities. This ratio, also known as “working capital ratio”, is a measure of general liquidity and is mostly used to make the analysis of a short term financial position or liquidity of a firm. It is calculated by dividing the total current assets by total of the current liabilities.
Thus,
Interpretation of Current Ratio:
A relatively high current ratio is an indication that the firm is liquid and has the ability to pay its current obligations in time as and when they become due. The rule of thumb is 2: 1 i.e. current assets double the current liabilities is considered to be satisfactory.
Quick Ratio or Liquid Ratio or Acid Test Ratio:
Quick 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 obligation as and when they become due. It may be defined as the relationship between the quick assets and current liabilities. An asset is said to be liquid if it can be converted into cash within a short period without loss of value. Hence inventory and prepaid expenses are excluded from the list of liquid assets because they are not expected to be converted into cash very easily.
Interpretation of Quick Ratio:
A high acid test ratio is an indication that the firm is liquid and has the ability to meet its current or liquid liabilities in time. As a rule of thumb quick ratio of 1:1 is considered satisfactory.
Absolute Liquid Ratio:
Absolutes liquid assets include cash, cash at bank and marketable securities or temporary investments. The acceptable norm for this ratio is 0.5:1
Liquid Assets Quick Ratio = _________________
Current Labilités Current Assets
Current Ratio = _____________
Current liabilities Current Labilités
Absolute liquid Assets
Absolute liquid ratio = __________________
Current liabilities
Inventory Turnover Ratio (or) Stock Turnover Ratio:
Every firm has to maintain a cretin level of inventory of finished goods so as to be able to meet the requirements of the business. But the level of inventory should neither be too high nor too low. It is harmful to hold more inventories for the following reasons:
(a) It is unnecessary blocks capital which can otherwise be profitably used somewhere else.
(b) Over stocking will require more go down space, so more rent will be paid.
(c) There are chances of obsolescence of socks. Consumers will prefer goods of latest design etc.
(d) There are chances of deterioration in quality if the stocks are held more periods.
Average inventory is calculated by adding the stock at the beginning and at the end of the period and dividing by it by two.
Interpretation of Inventory Turnover Ratio:
Inventory turnover ratio measures the velocity of conversion of stocks into sales.
Usually, a high inventory turnover/stock velocity indicates efficient management of inventory because more frequently the socks are sold and lesser amount of money is needed to finance the inventory. A low inventory turnover ratio indicates an inefficiently management of inventory.
Cost of goods sold Inventory Turnover Ratio = ________________
Average inventory
Debtors (or) Receivable Turnover Ratio & Average Collection Period:
A concern may sell goods for cash and credit. Credit is one of the important elements of sales promotion. The volume of sales can be increased by following a liberal credit policy.
But the effect of a liberal credit policy may result in tying up substantial funds of a firm in the form of trade debtors. Trade debtors are expected to be converted into cash within a short period and are included in current assets. Hence, the liquidity position of a concern to pay its short - term obligations in time depends upon the quality of its trade debtors.
Debtor‟s turnover indicates the velocity of debt collection of firm. In simple
words, it indicates the number of times average debtors (receivables) are turn over during the year. Thus,
Interpretation of Debtors Turnover Ratio:
Debtors velocity indicates the number of times the debtors are turned over during the year. Generally, higher the value of debtors turnover the more efficient is the management of debtors or more liquid are the debtors. Similarly, low debtors turnover implies inefficient management of debtors and less liquid debtors.
Creditors’ Turnover Ratio (or) Payables Turnover Ratio:
In course of business operations, a firm has to make credit purchases and incur short term liabilities. A supplier of goods, i.e., creditors, is naturally interested in finding out how much time the firm is likely to take in repaying its trade creditors. The ratio indicates the velocity with which the creditors are turned over in relation to purchases. Generally, higher the creditors‟ velocity better it is or other wise lower the creditors velocity, less favourable are the results.
Net Annual Credit Sales Debtors Turnover Ratio = ____________________
Average trade debtors
Cost of sales Working Capital turnover Ratio = _____________________
Average working capital
Interpretation of Average Payment Period:
The average payment period ratio represents the average number of days taken by the firm to pay its creditors. Generally, lower the ratio, the better is the liquidity position of the firm and higher the ratio, less liquid is the position of the firm.
Working Capital Turnover Ratio:
Working capital turnover ratio indicates the number of times the working capital is turned over in the course of a year. This ratio measures the efficiency with which the working capital is being used by a firm.
Net Annual Credit Purchases Creditors Turnover Ratio = _________________________
Average Trade Creditors
No of days in a year
Average Payment Period = _________________
Creditors turnover ratio
Computation of Working Capital:
The two components of working capital (WC) are current assets (CA) and current liabilities (CL).
STATEMENT OF WORKING CAPITAL REQUIREMENT:
(Pro-forma)
(I) Estimation of Current Assets. (Amount)
(a) Minimum desired cash and bank balances. xxxx (b) Inventories
Raw material xxxx Work-in-process xxxx
Finished Goods xxxxx xxxx (c ) Debtors xxxx
(d) sundry advances xxxxx
Total current assets (I) xxxx (II) Estimation of Current Liabilities
(a) Creditors xxxx
(b) Lag in payment of expenses, if any xxxx xxxxx
Total Current Liabilities (II) xxxxx (III) Net Working Capital ( I – II) xxxxx Add : Margin for contingency xxxxx
(IV) Net Working Capital Required xxxxx