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Ratio Analysis – Part 2 Liquidity Ratios Paper 3B: Financial Management Chapter 3 Unit I
CA B. Hari Gopal B.com, PGDBA, FCA, FCMA, DISA(ICAI), PMP (PMI, USA), EPBM (IIMC), MCT
Learning Objectives
1. Gain Knowledge on Liquidity Ratios
2. Usage of various Liquidity Ratios
3. Preparation of various Liquidity Ratios
2
Introduction to Liquidity Ratios
•Background •Types of Liquidity Ratios
3
4
Liquidity Ratio - Background
Liquidity and Short term solvency
Meaning of Liquidity
Impact of inability to pay short term liabilities
5
Types of Liquidity Ratios
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Current Ratio
Quick Ratio
Cash Ratio / Absolute Liquidity Ratio
Basic Defense Interval
Net Working Capital Ratio
Current ratio
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Current Ratio
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A ratio of less than 1 is a cause of concern, particularly if it persists for long time
Acceptable current ratio is 2 to 1.
Formulae - Current assets / Current liabilities
A simple measure that estimates whether the business can pay debts due within 1 year from assets that it
expects to turn in to cash within that year
Current Assets & Current Liabilities
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• Inventories + Receivables + Cash and Bank Balances + Loans and Advances +Disposable investments + Accruals
Current Assets
• Creditors for goods and services + Short Term Loans + Bank Overdraft + Cash Credit + Outstanding expenses + Provision for Taxation + proposed Dividend + Unclaimed Dividend
Current Liabilities
Illustration 1 – Current Ratio
10
Extract of BALANCE SHEET OF M/s HPCL Ltd as at 31-Mar-2009
Rs. Rs. Fixed Assets (Net Block) 30,000 Debtors 50,000 Cash at Bank 10,000 Stock 60,000 Total Current Assets (CA) 1,20,000 Creditors 50,000 Total Current Liabilities (CL) 50,000 Working Capital (CA-CL) 70,000 Total Assets 1,00,000 Find Current Ratio
Illustration 1 – Current Ratio 11
Current Ratio = Current Assets / Current Liabilities
Current Ratio 2.40
Current Assets Debtors 50,000 Cash at Bank 10,000 Stock 60,000
1,20,000
Current Liabilities
Creditors 50,000
Quick ratio
12
Quick Ratio
Other names – Acid Test Ratio or Liquid Ratio
It adjust the current ratio to eliminate all assets that are not already in cash or near cash form.
Formulae – Quick assets / Current liabilities
Acceptable Quick ratio is 1 to 1 is considered as satisfactory. A ratio of less than 1, would be a danger signal
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Quick Assets & Current Liabilities
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• Receivables + Cash and Bank Balances + Loans and Advances +Disposable investments + Accruals
Quick Assets
• Creditors for goods and services + Short Term Loans + Bank Overdraft + Cash Credit + Outstanding expenses + Provision for Taxation + proposed Dividend + Unclaimed Dividend
Current Liabilities
Illustration 2 – Quick Ratio
15
Extract of BALANCE SHEET OF M/s HPCL Ltd as at 31-Mar-2009
Rs. Rs. Fixed Assets (Net Block) 30,000 Debtors 50,000 Cash at Bank 10,000 Stock 60,000 Total Current Assets (CA) 1,20,000 Creditors 50,000 Total Current Liabilities (CL) 50,000 Working Capital (CA-CL) 70,000 Total Assets 1,00,000 Find Quick Ratio
Illustration 2 – Quick Ratio 16
Current Liabilities
Sundry Creditors 50,000
Quick Ratio = Quick Assets / Current Liabilities
Quick Ratio 1.20
Quick Assets
Debtors 50,000
Cash and Bank 10,000
60,000
Cash ratio
17
Cash Ratio
Also known as “Absolute Liquidity Ratio”
It eliminates any unknowns surrounding receivables.
Formulae – (Cash and Marketable securities) / Current liabilities
Cash Ratio tests only the short term liquidity in terms of cash and marketable securities
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Illustration 3 – Cash Ratio
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Extract of BALANCE SHEET OF M/s HPCL Ltd as at 31-Mar-2009
Rs. Rs. Fixed Assets (Net Block) 30,000 Debtors 50,000 Cash at Bank 10,000 Stock 60,000 Total Current Assets (CA) 1,20,000 Creditors 50,000 Total Current Liabilities (CL) 50,000 Working Capital (CA-CL) 70,000 Total Assets 1,00,000 Find Cash Ratio
Illustration 3 – Cash Ratio 20
Cash Ratio = Cash and Marketable Securities / Current Liabilities
Cash Ratio 0.20
Current Liabilities
Sundry Creditors 50,000
Cash
Cash at Bank 10,000
Basic Defense Interval
21
Basic Defense Interval
Helps to determine the number of days the company can cover its cash expenses without the aid of additional financing
Formulae – (Cash + Marketable securities + Receivables) / Cash Expenses per day
Cash Expenses per day – (Operating expenses + Interest + Income Taxes) / 365
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Net Working Capital
23
Net Working Capital
1
• Banks look at Net Working Capital over time to ascertain the firm’s ability to overcome the financial crisis.
2
• Formulae – • Current Assets – Current Liabilities
(excluding short term bank borrowing)
3
• The results of this calculation must be a positive number. Loans are often tied to minimum working capital requirements
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Testing time
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Liquidity Ratios - Multiple Choice Questions
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MCQ – 1
Quick ratio also known as –
A. Absolute liquidity ratio
C. Cash Ratio
B. Acid Test Ratio
D. None of the above
Answer: B. Acid Test Ratio
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MCQ – 2
Quick assets =
A. Current assets – Inventories – Prepaid expenses
C. Current assets + Inventories + Prepaid expenses
B. Current assets – Inventories
D. Current assets + Inventories
Answer : A. Current assets – Inventories – Prepaid expenses
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MCQ – 3
Cash Ratio also known as –
A. Acid Test Ratio
C. Absolute Liquidity Ratio
B. Coverage Ratio
D. None of the above
Answer : C. Absolute Liquidity Ratio
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MCQ – 4 The ratio that helps in determining the number of days the company can cover its cash expenses without the aid of additional financing is called as –
A. Current Ratio
C. Cash Ratio
B. Basic Defense Interval
D. Quick Ratio
Answer : B. Basic Defense Interval
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MCQ – 5
Working Capital =
A. Current Assets – Quick Liabilities
C. Current Assets – Current Liabilities
B. Quick Assets – Quick Liabilities
D. Quick Assets – Current Liabilities
Answer : C. Current Assets – Current Liabilities
31
MCQ – 6
Which ratio is the best known measure of financial strength –
A. Acid Test Ratio
C. Current Ratio
B. Cash Ratio
D. None of the above
Answer : C. Current Ratio
32
MCQ – 7
Current Ratio =
A. Current Assets / Quick Liabilities
C. Current Assets / Current Liabilities
B. Quick Assets / Quick Liabilities
D. Quick Assets / Current Liabilities
Answer : C. Current Assets / Current Liabilities
Lesson Summary
33
We had detailed discussions on Current Ratio, Quick Ratio, Cash Ratio, Basic Defense Interval and Net
Working Capital
We have learnt the meaning and purpose of Liquidity ratios
What Next ……
34
Follow the below Presentations
Ratio Analysis Part 1 – Ratio Analysis Overview
Ratio Analysis Part 3 – Leverage Ratios
Ratio Analysis Part 4 - Activity Ratios
Ratio Analysis Part 5 - Profitability Ratios
35
Thank You
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