Financial Statement Analysis-FIN621
4. ANALYSIS BY RATIOS:
Financial Ratios are like financial temperatures, which give the state of the health of a business.
This analysis technique is most widely used. In these inter-linkages of Income Statement and
Balance Sheet items are established and inferences are drawn there from.
The analysis technique by Ratios would broadly consist of the following:-
Analysis by short-term creditors: Interest of short-term creditors is to watch the
ability of business to meet its debts as these become due; i.e. Short-term solvency.
They want to see whether business has the ability to meet its current liabilities out
of its current assets. I the entity can not maintain a short-term debt paying ability, it
will not be able to maintain a long-term debt-paying ability, nor will it be able to
satisfy its stockholders. Even a very profitable entity will find itself bankrupt if it
fails to meet its obligations to short-term creditors. The ability to pay current
obligations when due is also related to the cash-generating ability of the firm. While
analyzing the short-term debt-paying ability of the firm, we find a close relationship
between the current assets and the current liabilities. Generally the current liabilities
will be paid with cash generated from the current assets. Profitability of the firm
does not determine the short-term debt paying ability. Indicators of this ability are
the short-term solvency ratios, which are:-
Liquidity Ratios are used to measure a firm's ability to meet short-term obligations.
They compare short-term obligations to short-term (or current) resources available to meet these
obligations. From these ratios, much insight can be obtained into the present cash solvency of the
firm and the firm's ability to remain solvent in the event of adversity.
Current ratio = Current assets
(Normal ratio for this is 2:1)
Current assets divided by current liabilities. It shows a firm's ability to cover its current
liabilities with its current assets. Higher the current Ratio, the greater the ability of the firm to pay its
bills; however, the ratio must be regarded as a crude measure because it does not take into account the
liquidity of the individual components of the current assets composed principally of cash and non-
overdue receivables is generally regarded as more liquid than a firm whose current assets consist
primarily of inventories. Consequently, we turn to a more critical, or sever, test of the firm's liquidity-
the acid test ratio
i.e. Current assets should be twice the current liabilities. It should however be noted
that too high ratio may indicate that capital is not being used productively and
efficiently. Such a situation calls for financial reorganization.
Quick ratio. This is also called acid-test ratio. In this, inventories and pre-paid
expenses are excluded from current assets. Only cash, marketable securities and
Receivables (called Quick Assets) are considered. For Quick Ratio, the normal ratio is
1:1 i.e. quick assets should be equal to current liabilities. It should be noted that current
ratio measures "general liquidity", whereas quick ratio measures "immediate liquidity".
Acid Test Ratio = Current assets- Inventories/ Current Liabilities
This ratio serves as a supplement to the current ratio in analyzing liquidity. This ratio is
the same as the current ratio except that it excludes inventories. Presumably the least
Financial Statement Analysis-FIN621
liquid portion of current-assets-from the numerator. The ratio concentrates primarily on
the more liquid current assets, cash, marketable securities, and receivables, in relation to
current obligations. Thus, this ratio provides a more penetrating measure of liquidity
than does the current ratio.
Cash Ratio = Cash Equivalents + Marketable Securities/ Current Liabilities
The cash ratio indicates the immediate liquidity of the firm. A high cash ratio indicates that the
firm is not using its cash to its best advantages; cash should be put to work in the operations of
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