Liquidity Ratios | Current Ratio | Working Capital Ratio | Quick Ratio
Financial ratios are typically used in the process of analysing trends and also comparing the organization’s financial position to other firms.
The financial ratios are primarily tools for turning the date enclosed in financial statements into information used by managers and executives to better comprehend what is happening in a company.
Financial ratios are highly advantageous indicators of an organisation’s performance as well as financial environment.
Financial ratios are typically used in the process of analysing trends and also comparing the organization’s financial position to other firms.
In few instances, an effective analysis conducted by financial ratios can help to predict the forthcoming bankruptcy or economic failure.
Financial ratios can typically be grouped according to the data they make available.
You Should Remember
Financial ratios can typically be grouped according to the data they make available. However, there are a few important yet frequently used ratios as mentioned below:
Liquidity ratios,
Asset turnover ratios,
Financial leverage ratios,
Profitability ratios,
Dividend policy ratios.
Financial Leverage Ratios | Debt | Total Assets | Equity | Times Interest Earned
Profitability Ratios | Gross Profit Margin | Return On Assets | Return On Equity
Dividend Policy Ratios | Dividend Yield | Payout Ratio | Key Procedural Aspects
Liquidity Ratios
Liquidity ratios principally measure the organisation’s ability to pay off short-term debt obligations. Most evidently, liquidity ratios can be used to comprehend whether or not an organisation is in difficulty and to assess their ability to make loan payments or pay suppliers.
A part from that, they can also be used to judge an organisations’ ability to take on more debt, or spend more cash, to explore new Resources for growth through modernization or acquisition.
There are ‘two’ regularly used liquidity rations; the current ratio (or working capital ratio) and the quick ratio.
The Current Ratio
The current ratio is the ratio of current assets to current liabilities:
The current ratio compares all the current assets of the organisation (cash and other assets that can be rapidly and easily transformed to cash) with all the organisation’s current liabilities (liabilities that must be paid with cash in a little while).
When it comes to negative side of the current ratio, major disadvantage is that inventory may contain several substances that are tough to liquidate quickly and that have uncertain liquidation values.
The Quick Ratio
The quick ratio is similar to the current ratio but is a more difficult measure of liquidity as it excludes inventory from current assets. To compute the quick ratio, then, divide current assets less inventory by current liabilities.
The quick ratio is defined as follows:
The quick ratio frequently is referred to as the acid test. The current assets used in the quick ratio are cash, financial records receivable, and notes receivable, in which these assets fundamentally referred to as current assets less inventory.
Common liquidity ratios include the following:
- Acid Test
- Cash Conversion Cycle
- Cash Ratio
- Current Ratio
- Operating Cash Flow
- Quick Ratio
- Working Capital
Limitations of Financial Ratios
Those who practice financial ratio analysis for decision-making processes must also be conscious of its limitations. Indeed, there are several limitations that influence in contrast to their effectiveness. Those are as follows;
1. The financial analysis cannot be a factual guide to organisation’s performance as it does not help the financial analyst drive deep into operational details.
For example, if an organisation does not keep up a sound depreciation policy and announces huge profits, high profitability ratios would basically be deceptive.
2. The values of the current assets as well as amount produced change frequently which may create misrepresentations in accounting measures of performance and financial situation.
3. The reliability of the standards against which the ratios are seen, is frequently uncertain. Except the norm is consistent, any implication drawn on the basis of ratios may be deceptive.
Hence, those who deal with the ratios must supplement the financial ratio analysis with substitute implements in order to test its trustworthiness.
Concept & Definition of Accounting ?
Characteristics of Accounting ?
Key Differences Between Accounting & finance ?
basis of accounting: Cash Basis & Accrual Basis ?
Fundamental Financial Accounting Assumptions, Principles & Conventions
Core Steps in Accounting Cycle | During & End of Accounting Period
4 Financial Statements | Balance Sheet | Retained Earnings | Cash Flows
The Balanced Scorecard | Comprehensive Knowledge | Measures | Perspectives
Capital Budgeting | Definitions | Features | Process | FIVE Stages
Capital Budgeting Decisions | Criteria | Substitute Directions | Implications
Dividend Policy Ratios | Dividend Yield | Payout Ratio | Key Procedural Aspects
Financial Leverage Ratios | Debt | Total Assets | Equity | Times Interest Earned
Profitability Ratios | Gross Profit Margin | Return On Assets | Return On Equity
