I) Liquidity / Short Term Solvency Ratio

Liquidity means ability of business to pay its short term liabilities. Inability to pay
its short term liabilities on due date will disturb the smooth running of the business
and affects the credibility of the business.

1) Current Ratio

Current Assets
=
Current Liabilities

Current Assets = Inventories + Sundry Debtors & B/R + Cash/Bank + Loans &
Advances + Marketable Securities.

Current Liabilities = Creditors & Bills Payable + Other Short term Borrowings +
Expenses Payable + Net Tax Payable + Any other liability payable in short period
of time.

Higher current ratio means better is the liquidity position. The traditional belief is
that 2:1 or higher current ratio is an indicator of good liquidity position. However
standard ratio varies from industry to industry.

2) Liquid Ratio Or Quick Ratio Or Acid Test Ratio

Quick Assets
=
Current Liabilities

Current Assets – Closing Stock – Prepaid Expenses

=
Current Liabilities

Quick Ratio provides ultimate test of liquidity. Due to some of the non – liquid
Current Assets, Current ratio gives distorted liquidity position. Hence current ratio
& liquid ratio both should be calculated to judge liquidity position. Generally liquid
ratio of 1:1 indicates good liquidity position.

II) Leverage Ratios or Capital Structure / Long Term Solvency Ratio

These ratios focuses on long term solvency position of the company. It gives the
idea about proportion of Debt fund in total funds employed. Debts should be
always within reasonable limit. Excess Debts gives rise to insolvency risk.
A) Debt/ Equity Ratio

Debt i.e. Borrowed Funds

=
Equity i.e. Owner’s Fund

Debt = Long Term Loans + Debenture / Bonds + Accrued Interest thereon +

Deferred payment liabilities (All should have initial maturity period of 5 years or
more).

Equity = Equity & Preference Share Capital + Reserves – Miscellaneous

expenditure.

Norm of 2:1 is suggested for this ratio. Higher the debt fund used in the capital
structure, greater is the risk. This risk is called financial risk. Since business income
fluctuates over the time for many reasons, in the year of low income, the business
may not be able to make payment of interest to suppliers of the loan fund. This
ratio is also called leverage ratio. This lever operates favourably if the rate of interest
is lower than the return on capital employed.

B) Debt Ratio

Debt
=
Capital Employed i.e. Debt + Equity

This ratio indicates proportion of Debt in Total Capital Employed. High ratio means
financial risk / burden on the company to pay fixed interest will be high. High ratio
will bring high returns to Equity Shareholders during growth period, provided return
on capital employed is higher than interest / preference dividend rate. In the year
of low income it will have adverse effect.

C) Debt to Total Assets Ratio

This ratio is calculated to judge outsider’s contribution in total assets acquired.

All outsider’s Fund i.e. Current + Non-Current Liabilities

=
Total Assets (excluding Miscellaneous Expenditure)

If the ratio is 60% implies owners have contributed 40% to buy assets.
In general, the lower the debt to total assets ratio, the higher the degree of
protection enjoyed by the creditors.
D) Proprietory Ratio

This ratio is calculated to judge the owner’s contribution to total assets acquired.

Proprietor’s Fund X 100

=
Total Assets (excluding Miscellaneous Expenditure)

High ratio means higher contribution of proprietors in total assets of the company
& therefore sound solvency position. If debt – equity ratio is high, proprietary ratio
will be low.

E) Capital Gearing Ratio

Funds with Fixed Interest & Dividend

=
Funds without fixed Interest & Dividend

Debt + Preference Share Capital

=
Equity – Preference Share Capital
If the ratio is higher than 1 than it implies high gearing. It means financial risk /
burden on the company to pay fixed interest will be high. High gearing ratio will
bring high returns to ESH in the growth period, provided return on capital employed
is higher than interest / preference dividend rate. In the year of low income it will
have adverse effect.

Q.1
Calculate Liquidity Ratios from the following.
X Ltd. Y Ltd. X Ltd. Y Ltd.
Current Liabilities Current Assets
Proposed dividend 51,800 32,000 Stock in trade 150,000 300,000
Unclaimed dividend 7,000 4,000 Sundry debtors 182,000 115,000
Sundry creditors 116,200 94,300 Loose Tools 14,000 9,000
Bank overdrafts 35,000 38,000 Cash & Bank balance 36,000 38,000
Provision for taxation 63,000 39,000 Marketable investment 63,000 39,000
Prepaid expenses 21,000 14,000
Temporary advances 16,800 11,000
273,000 207,300 482,800 526,000
Solution
X Ltd Y Ltd
Current Assets (a) 482800 526000
[-] Stock -150000 -300000
[-] Loose Tools -14000 -9000
[-] Prepaid Expenses -21000 -14000
Quick Assets (b) 297800 203000
 Current Liabilities [c] 273000 207300

Current Ratio [a / c] 1.77 2.54

Quick Ratio [b / c] 1.09 0.98

Q.2
Balance Sheet as at 31st December, 2019
Liabilities Rs Assets Rs
Equity share capital 250,000 Fixed Assets 420,000
12% preference share capital 100,000 Current Assets 367,000
Investment allowance reserve 15,000
General Reserve 35,000
Profit and Loss A/c. 25,000 Preliminary expenses 20,000
13.5% Secured debentures 100,000
Secured loans 87,000
Current Liabilities 195,000
807,000 807,000
Calculate long term solvency (i.e. capital structure) Ratios and offer your comments.

Solution
Equity Share Capital 250000
Investment Allowance Reserve 15000
General Reserve 35000
Profit & Loss a/c 25000
[-] Preliminary Expenses -20000
Equity Shareholder's Fund A 305000
12% Preference Share Capital B 100000
Shareholder's Fund C 405000
13.5% Secured debentures 100000
Secured loans 87000
Total Debt D 187000
Current Liabilities E 195000
Total Assets = Total Liabilities F 787000

Debt Equity Ratio D/C 0.46

Debt Ratio D / (C+D) 0.32

Debt to Total Assets (D+E)/F 0.49

Proprietary Ratio C/F 0.51

Capital Gearing Ratio (D+B)/A 0.94