LIQUIDITY RATIOS

Liquidity ratios are the ratios that measure the ability of a company to meet its short term
debt obligations. These ratios measure the ability of a company to pay off its short-term
liabilities when they fall due.
Generally, the higher the liquidity ratios are, higher is the margin of safety that the company
possess to meet its current liabilities. Liquidity ratios greater than 1 indicate that the company
is in good financial health and it is less likely fall into financial difficulties.
Most common examples of liquidity ratios include current ratio, acid test ratio (also known as
quick ratio), cash ratio and working capital ratio.

CURRENT RATIO:
The current ratio indicates a company's ability to meet short-term debt obligations. The
current ratio measures whether or not a firm has enough resources to pay its debts over the
next 12 months. Potential creditors use this ratio in determining whether or not to make short-
term loans. The current ratio can also give a sense of the efficiency of a company's operating
cycle or its ability to turn its product into cash.
current ratio = Current Assets / Current Liabilities
Higher the ratio, the more liquid the company is. Commonly acceptable current ratio is 2; it's
a comfortable financial position for most enterprises.
Low values for the current ratio (values less than 1) indicate that a firm may have difficulty
meeting current obligations. However, an investor should also take note of a company's
operating cash flow in order to get a better sense of its liquidity. A low current ratio can often
be supported by a strong operating cash flow.

QUICK / ACID TEST / LIQUID RATIO:
The term Acid-test ratio is also known as quick ratio. The most basic definition of acid-
test ratio is that, it measures current (short term) liquidity and position of the company. To
do the analysis accountants weight current assets of the company against the current
liabilities which result in the ratio that highlights the liquidity of the company.

Quick ratio = (Current Assets Inventory) / Current liabilities
This concept is important as if the companys financial statements ( income statement,
balance sheet) get through the analysis of the acid-test ratio, then the short term debts can be
paid by the company.



Operational efficiency or Turnover ratios
operational efficiency can be defined as the ratio between the input to run a business operation
and the output gained from the business. When improving operational efficiency, the output to
input ratio improves.
Inputs would typically be money (cost), people (headcount) or time/effort. Outputs would
typically be money (revenue, margin, cash), new customers, customer loyalty, market
differentiation, headcount productivity, innovation, quality, speed & agility, complexity or
opportunities.
Capital Turnover ratio
Capital Turnover Ratio indicates the efficiency of the organization with which the capital
employed is being utilized. A high capital turnover ratio indicates the capability of the
organization to achieve maximum sales with minimum amount of capital employed. Higher
the capital turnover ratio better will be the situation.
capital turnover ratio = Sales/ Capital Employed
It indicates the firms ability to generate sales per rupee of capital employed. The higher the ratio,
the greater is the sales made per rupee of capital employed in the firm and hence higher is the
profit. A low capital turnover ratio refers to low sales generated in relation to capital employed or
excessive capital being used by the firm.

Total asset turnover ratio ******
The total asset turnover ratio measures the ability of a company to use its assets to efficiently
generate sales. This ratio considers all assets, current and fixed. Those assets include fixed assets,
like plant and equipment, as well as inventory, accounts receivable, as well as any other current
assets.
Total asset turnover ratio=Net Sales/Total Assets


Fixed asset turnover ratio
A financial ratio of net sales to fixed assets. The fixed-asset turnover ratio
measures a company's ability to generate net sales from fixed-asset
investments - specifically property, plant and equipment (PP&E) - net of
depreciation. A higher fixed-asset turnover ratio shows that the company has
been more effective in using the investment in fixed assets to generate
revenues.
Fixed asset turnover ratio= Net sales/net total fixed assets
It indicates the firms ability to generate cells per rupee of investment in fixed assets. In general,
higher the ratio, the more efficient is the management and utilisation of fixed assets, and vice versa.

Working capital turnover ratio
Working capital turnover ratio is an activity ratio that measures dollars of revenue generated per
dollar of investment in working capital. Working capital is defined as the amount by which current
assets exceed current liabilities.

A higher working capital turnover ratio is better. It means that the company is utilizing its working
capital more efficiently i.e. generating more revenue using less investment.
Stock turnover ratio
A ratio showing how many times a company's inventory is sold and replaced over a period.
The days in the period can then be divided by the inventory turnover formula to calculate the
days it takes to sell the inventory on hand or "inventory turnover days."
Stock Turnover Ratio = Cost of Goods Sold/Average Inventory at Cost
A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies
either strong sales or ineffective buying. High inventory levels are unhealthy because they
represent an investment with a rate of return of zero.
Inventory conversion period
The inventory conversion period is the time required to obtain materials for a product,
manufacture it, and sell it. The inventory conversion period is essentially the time period during
which a company must invest cash while it converts materials into a sale.
Inventory conversion period = 365 days
inventory turnover ratio
Less inventory conversion period is better because more fastly, we will convert our
inventory into sales, there will be less chance of obsolescence and paying of over-
stocking cost. Inventory conversion period is the part of cash conversion cycle. If this
period is very high, it will increase the time to complete the cash conversion cycle. It
means, there will be more liquidity risk in that level of inventory.
Debtors turnover ratio
It's anefficiency ratio or activity ratio that measures how many times a business can turn
its accounts receivable into cash during a period. In other words, the accounts
receivable turnover ratio measures how many times a business can collect its average
accounts receivable during the year.
Debtors turnover ratio= net credit sales
average trade debtors
A high ratio implies either that a company operates on a cash basis or that its extension of
credit and collection of accounts receivable is efficient.

A low ratio implies the company should re-assess its credit policies in order to ensure the
timely collection of imparted credit that is not earning interest for the firm.
Creditors turnover ratio
It is a short-term liquidity measure used to quantify the rate at which a
company pays off its suppliers. Creditors turnover ratio is calculated by
taking the total purchases made from suppliers and dividing it by the
average accounts payable amount during the same period.
Creditors turnover ratio = net credit purchase
average trade creditors
The average payment period ratio represents the average no 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. But a high payment period also implies greater credit period
enjoyed by the firm and consequently larger the benefit and reaped from
credit supplier.
Debt payment period***
Debt payment period shows an average period for which the credit purchases remain outstanding or the average
credit period which is actually availed.
Debt payment period= 365 days
creditors turnover ratio

Profitability ratio:
Profitability ratios measure a companys ability to generate earnings relative to sales, assets
and equity. These ratios assess the ability of a company to generate earnings, profits and cash
flows relative to relative to some metric, often the amount of money invested. They highlight how
effectively the profitability of a company is being managed.
Common examples of profitability ratios include return on sales, return on investment, return on
equity, return on capital employed (ROCE), cash return on capital invested (CROCI), gross profit
margin and net profit margin. All of these ratios indicate how well a company is performing at
generating profits or revenues relative to a certain metric.
Gross profit margin ratio
The gross profit margin ratio expresses the gross profit as a proportion of sales. The gross
profit margin ratio is used as one indicator of a business's financial health. It shows how
efficiently a business is using its materials and labour in the production process and gives an
indication of the pricing, cost structure, and production efficiency of your business. The
higher the gross profit margin ratio the better.
Gross profit ratio = Gross profit X 100
net sales
The higher the percentage, the more the business retains of each dollar of sales, which means
more money is left over for other operating expenses andnet profit.
A low gross profit margin ratio means that the business generates a low level of revenue to
pay for operating expenses and net profit. It indicates that either the business is unable to
control production and inventory costs or that prices are set too low.
Net profit margin
The ratio of net profits to revenues for a company or business segment -
typically expressed as a percentage that shows how much of each dollar
earned by the company is translated into profits.
Net profit margin= net profit/ sales*100
A low profit margin indicates a low margin of safety: higher risk that a decline in sales will erase profits
and result in a net loss. The higher the margin is, the more effective the company is in converting
revenue into actual profit.
Operating profit ratio
This ratio measures the relationship between operating profits and net sales. The main objective of
computing this ratio is to determine the operational efficiency of the management.
Operating profit ratio=(operating profit/net sales)*100
Higher the ratio the more efficient is the operating management and vice versa.
Earning per share:
Earnings per Share (EPS) of a business is the portion of its net income of a period that can be
attributed to each share of its common stock.
Earnings per Share (EPS) = (net profit after tax/ number of equity shares)*100

Return on Equity interpretation
Return on Equity (ROE) is an indicator of company's profitability by measuring how much profit the
company generates with the money invested by common stock owners. It is also known as Return on
Net Worth.

Generally, the industries which are capital-intensive and with a low return on equity have a limited
competition. But, the industries with high return on equity and small assets bases have a much higher
competition because it is a lot easier to start a business within those industries.
Return On Capital Employed
A financial ratio that measures a company's profitability and the efficiency
with which its capital is employed. Return on Capital Employed (ROCE) is
calculated as:

ROCE = Earnings Before Interest and Tax (EBIT) / Capital Employed
A higher ROCE indicates more efficient use of capital. ROCE should be higher
than the companys capital cost; otherwise it indicates that the company is
not employing its capital effectively and is not generating shareholder value.




PROPRIETORY RATIO
The proprietary ratio (also known as the equity ratio) is the proportion of shareholders' equity to
total assets, and as such provides a rough estimate of the amount of capitalization currently used
to support a business. If the ratio is high, this indicates that a company has a sufficient amount of
equity to support the functions of the business, and probably has room in its financial structure to
take on additional debt, if necessary. Conversely, a low ratio indicates that a business may be
making use of too much debt or trade payables, rather than equity, to support operations.


Capital gearing
Capital gearing ratio is a useful tool to analyze the capital structure of a company and is computed
by dividing the common stockholders equity by fixed interest or dividend bearing funds.
Analyzing capital structure means measuring the relationship between the funds provided by common
stockholders and the funds provided by those who receive a periodic interest or dividend at a fixed
rate.
A company is said to be low geared if the larger portion of the capital is composed of common
stockholders equity. On the other hand, the company is said to be highly geared if the larger portion
of the capital is composed of fixed interest/dividend bearing funds.

Preference capital+ secured loan
Capital gearing ratio = Equity capital & reserve & surplus

DEBT-EQUITY RATIO
A measure of a company's financial leverage calculated by dividing its total liabilities by
stockholders' equity. It indicates what proportion of equity and debt the company is using to
finance its assets.
Debt equity ratio= Long term debt/Net worth
A high debt/equity ratio generally means that a company has been aggressive in financing its
growth with debt. This can result in volatile earnings as a result of the additional interest
expense.