All about Liquidity Ratio and its Calculation | ApnaCourse
Manu and Vinu about
|Manu||Hi Vinu, Long time – no see??? Why are looking sad?|
|Vinu||Manu, Yesterday I’ve gone to the Commercial Bank where our Company has various
|Vinu||Credit Officers in the Bank have thrashed me into pieces!|
|Manu||Why, what happened?|
|Vinu||They just took our Company’s Balance Sheet, scanned them for 5 – 10 minutes and
– Our Company is not doing well;
– We are having liquidity problems and won’t pay short term creditors on time;
– Our Assets are not utilised effectively (how do they know?);
– We are highly leveraged (which of course, I didn’t understand);
– We are going to face severe problems in the downturn (how they can say that??);
– We may have to book huge losses, if certain cases go against us;
And hell a lot….
|Manu||Be Cool Vinu…|
|Vinu||When they said,
a) We are having liquidity problems and won’t pay short term creditors on time;
I thought some of our creditors would have told them.
b) Our Assets are not utilised effectively
I thought how they know this even without seeing our assets?;
c) We are highly leveraged!
I thought what the hell that was?
d) We are going to face severe problems in the downturn
I thought how they can say that????;
e) We may have to book huge losses, if certain cases go against us;
I thought who gave them details about our cases???
|Vinu||I was wondering how they can say all these in just 5-10 minutes just by reading Balance
|Manu||Vinu! If not for answering all these, then for what purpose Balance Sheet – aka-
Financial Statements are prepared?
|Vinu||I am sorry Manu. I couldn’t understand.|
|Manu||Vinu! Please understand the very purpose of preparing financial statements is to
provide information like these to the stake holders.
|Vinu||But I have also read Balance Sheets. I have never seen these stuffs in Balance Sheets.|
|Manu||It means, you have NOT understood Financial Analysis.
Or, I would say, you don’t know how to read Balance Sheet
|Vinu||Manu, please don’t say that. In Accounting papers, always I have been correct in
preparing Financial Statements. Always my Balance sheet will tally and I used to score
good marks too….
|Manu||But, that is Accounting!!!|
|Manu||Yes! That is Accounting. There your focus is preparing Financial Statements by following
Generally Accepted Accounting Principles and Practices.
By being an Accountant you will focus on Accounting Procedures, Presentations,
But, what for these all?
|Vinu||Yes? What for these all?|
|Manu||It’s all for reading by stake holders.
Stake holders like Investors, Lenders, Creditors, Employees, etc. are going to read your Balance Sheet. They read your Balance Sheet to assess your Company!
They read your Balance Sheet to understand risk involved!
They read your Balance Sheet to understand your
– Cash generating capacity;
– Return on Investments;
– Debt Repayment Capacity;
– Owners Contribution to the Business;
– Extent of dependence on Outsiders for running your Business;
– Income which you make from your Operating and Non-Operating Activities;
– Expenses incurred on your Operating and Non-Operating Activities;
You know, there is a saying called “Face is the Index of the Mind”
In case of Business Entities, Balance Sheet is their Face.
How I can develop Balance Sheet reading ability?
Already I know, how to prepare Balance Sheet. Will that be sufficient?
|Manu||Vinu! Actually for reading Balance Sheet, you need not be an Accountant.
Imagine from those Bankers point of view. Most of them would be Non Finance
Executives may be even Engineering or Science graduates.
But they were able to read your balance sheet and tear you into pieces.
How did this happened?
It’s because, they have developed their skill to read Balance Sheet.
|Manu||Yes! Balance Sheet reading is a skill which any one can develop through practice.|
|Manu||There are various Financial Ratios which will help you to read the Balance Sheet.|
|Manu||Yes! But before I explain you Ratios, let’s understand why we should use ratios for reading balance sheet. When I say Balance Sheet, it includes Profit and Loss also. Ok?|
|Manu||Let’s assume, there are two companies A Ltd and B Ltd and each report profit of
Rs.10 Cr and Rs.5 Cr respectively.
|Manu||If you have some cash for investment, in which company you will be investing. Would
it be A Ltd or B Ltd?
|Vinu||Hmmm….A Ltd makes more profit than B Ltd
So, I’ll invest in A Ltd.
But what will be your decision, if A Ltd reports sales of Rs.100 Cr and B Ltd reports sales
of only Rs.20 Crs.
|Vinu||Let me tabulate that first.
I think I should change my mind.
|Vinu||On look A Ltd’s profit is good. But, if i look at the profit margin of A Ltd, it is only 10% whereas B Ltd has a Profit margin of 25%.|
|Manu||Wow…how did you found that?|
|Vinu||I just compared profit with sales and expressed it in percentage. Like this
You compared Profit with Sales.
This comparison helped you to form a new ratio called Profit Margin.
And Profit Margin helped to you to take a correct decision.
I am saying correct decision, because, previously you selected A Ltd as Investment option, when you just had information about Profits.
But, when you derived a ratio called Profit Margin, you were able to make meaningful analysis and select the best one.
|Manu||Whenever you derive ratios, you have to ensure, you are comparing only meaningful numbers. If you do so, the derived ratio will be meaningful and it will help you to understand various financial aspects.|
|Vinu||Really? I am thrilled to compute more ratios. How many ratios are there?|
|Manu||Hmm….Sometimes it is even left to our creativity.
But I’ll teach you the ratios which are widely used in the industry.
|Manu||Broadly ratios can be categorised into four categories.|
a) Liquidity Ratios;
b) Capital Structure / Leverage Ratios;
c) Activity Ratios;
d) Profitability Ratios.
|Manu||First, let’s start with Liquidity Ratios.|
|Vinu||Ok. Why we have to find liquidity ratios? I mean, what’s the purpose?|
|Manu||It’s basically to know whether you have adequate liquidity!|
|Manu||Hmmm….Liquidity means, whether you have adequate short term resources to pay your short term obligations.|
|Vinu||Can you make it little simpler?|
|Manu||Ok…Liquidity means, you are not strained to meet your obligations. i.e., you have more
resources (can be current assets) and less obligations (current liabilities)
|Manu||So, through liquidity ratios, basically we would try to understand how comfortable the liquidity position of the business.|
|Vinu||But, why so much stress on liquidity?|
|Manu||Vinu! It’s really dangerous to have stressed liquidity position.
Let whatever be the Networth of your Business.
If liquidity is not managed, then even God cannot save that business?
|Vinu||Don’t be joking!!!|
Let me give you a real example!
I have seen a company which was set up at a cost of Rs.75 Crs some 15 years back.
|Manu||Do you know, how they arranged this Rs.75 Crs?|
|Vinu||You have to tell meJ|
|Manu||The grave mistake done by the company is arranging Rs.2 Crs of Short Term Funds for
funding their long term project.
|Manu||This company would break even only after 3 years. But they have to repay short term loan of Rs.2 Crs within one year.
So sadly, this company couldn’t repay that short term loan.
|Vinu||What happened then?|
|Manu||Short term lender has approached the court for liquidation of the company and pay back the loan.|
|Manu||Court passed liquidation order and for the past 15 years, litigation is going on with no operations in the company.
Why did all these happened?
|Vinu||Because, they could not pay their short term lenders.|
|Manu||Yes! They are the most dangerous lenders and they have to be handled very carefully failing which they will ensure our business don’t continue longer.
Hence, the importance of Liquidity Management and the liquidity ratios.
|Vinu||I got it.|
|Manu||There are many ratios in Liquidity. But ill confine to four ratios now.|
a) Current Ratio
b) Quick Ratio
c) Cash Ratio
d) Defence Interval Ratio
|Vinu||Current Ratio we have already discussed.|
It will be available in this link
|Vinu||What is Quick Ratio? Or Why we should calculate Quick Ratio?|
|Manu||That’s a good question. Why we should calculate Quick Ratio when we already calculate
The answer is “Quick Ratio is an extension of Current Ratio”.
Sometimes, mere dependence of current ratio will be misleading.
|Manu||Let’s say, you have current asset of Rs.100 Crs and Current Liability of Rs.50 Crs.|
|Manu||Can you calculate Current Ratio?|
|Vinu||Yes! It’s very simple.
Current Ratio = Current Assets / Current Liabilities
= 100 /50
= 2 Times
|Manu||Great! What does it communicate?|
|Vinu||I have resources twice that of obligations. I should be happy.|
|Manu||Fine. Let me give break up of your current assets and current liabilities and let me see whether your happiness continues!
|Vinu||What’s wrong in this?|
|Manu||You have to pay Rs.50 Crs to Sundry Creditors. i.e., your suppliers – right?|
|Manu||What are the resources you have?|
|Manu||How much you can pay immediately to your suppliers?|
|Vinu||Hmm…Rs.10 Crs (Cash and Bank Balances)|
|Manu||You can also pay another Rs.15 Crs, if you are going to realise your receivables.|
|Manu||So, you can pay Rs.25 Crs quickly. But still, you may have to pay another Rs.25 Crs to complete Rs.50 Crs obligation.|
|Manu||What resources you have to pay that?|
|Vinu||Inventory of Rs.75 Crs.|
|Manu||Will you return back Inventory of Rs.25 Crs?????|
|Vinu||Hmmm…..i may not be ….because I need inventory for sales.|
|Manu||Yes! Your inventory may be in various forms.
If it is in the form of Raw Material,
-then it has to be consumed in the production process,
-converted into finished goods,
-customer should be identified,
– sales have to be made, and
– if it is credit sales, you won’t get money immediately.
All these would take time!!!
|Vinu||Yes! I understand.|
|Manu||So, understand, Inventory, though it is a current asset, it is not a quick asset.|
|Manu||But many of your current liabilities may be quick liabilities. Though not separated.|
|Manu||So, this is the reason to find Quick Ratio.
i.e., Find out the quick assets out of your current assets.
|Vinu||By subtracting Inventory from Current Assets?|
|Manu||Yes. Also subtract Prepaid Expenses. Because, it is already paid and it will only reduce future accounting expenses.|
|Manu||So Quick Assets is equal to…..|
|Vinu||I’ll do it.
Quick Assets = Current Assets – Inventory – Prepaid Expenses
|Manu||Good! How would you compute Quick Ratio?|
|Vinu||Quick Ratio = Quick Assets / Current Liabilities|
|Vinu||How Quick Ratio should be?|
|Manu||For that, answer me, how current ratio should be?|
|Vinu||Current Ratio should be at least 1.33. Meaning, Current asset should be at least 1.33 times of Current Liability.|
|Manu||If Current Ratio should be at least 1.33, then Quick Ratio should be at least 1 Time. i.e.,
Quick asset should be at least equal to current liability.
|Vinu||Yes! That makes sense.
Current assets should be greater than current liability but quick assets should be at least equal to current liability so liquidity position can be managed.
|Manu||Sometimes Quick Ratio is also calculated as
Quick Assets / Quick Liabilities.
|Manu||Yes! Out of Current liabilities, certain liabilities may not be quick. They are almost permanent liabilities.|
|Manu||Like Bank Overdraft / Cash Credit?|
|Manu||Yes! Because, you can pay them and re-avail immediately. So, those limits will roll after continuously if you have credit sanction in place.|
|Manu||In such cases, Quick liabilities are calculated as
Quick Liability = Current Liability – Bank Cash Credit – Bank Overdraft
|Vinu||And Quick Ratio is calculated as
Quick Ratio = Quick Assets / Quick Liabilities
We shall move on to the next ratio.
It is Absolute Liquidity Ratio.
|Manu||This ratio is calculated to know absolute liquidity position of the company. i.e., if all the current liabilities have to be settled immediately, what are the cash resources available?|
|Manu||In such cases, you cannot expect stock and receivables to convert into cash immediately.|
|Manu||So, for calculating Absolute Liquidity Ratio, you should find absolute Liquid Assets.|
|Vinu||What are they?|
|Manu||They should your
a) Cash and Bank Balances
b) Marketable Securities.
c) Short Term Securities.
|Manu||These resources should be compared with current liabilities.|
|Vinu||Do we have any standard or bench mark ratio for this?|
|Manu||There is no standard ratio as such. But if you have ratio like 1:1 or 1 Time, it would indicate you carry too much of cash resources.|
|Vinu||But what’s wrong in that?|
|Manu||You are carrying idle resources which are not going to generate any revenue for you but would only incur cost.|
|Manu||So, this ratio would depend upon the circumstances.|
|Vinu||And the formula?|
|Manu||Forgot to give that.
Absolute Liquid Ratio = (Cash + Marketable Securities) / Current Liabilities
|Vinu||Fine. What was that fourth ratio?|
|Manu||It is Basic Defence Interval Measure.|
|Vinu||When we will use this ratio?|
|Manu||We can use this ratio for two scenarios.
One to know, how long the company can manage its operations when it is in the stages of winding up.
Two, it can also be used to measure the ability to meet cash expenses.
|Vinu||Can you make it little clear.|
|Manu||Ok. Actually, this ratio is expressed in number of days. It would let us know, how long we will be able to manage our cash expenses with available cash resources.|
|Vinu||Oh…How do we calculate Cash Resources?|
|Manu||It’s nothing but Quick Assets.|
|Vinu||And what are the Cash Expenses?|
|Manu||It can be your Total Expenses adjusted for Non-Cash Items.|
|Manu||Depreciation / Write offs etc.|
|Vinu||Ok. So, how do we calculate this ratio?|
|Manu||First, you have to find Cash expenses per day.|
|Vinu||Cash Expenses per day = (Total Expenses – Non Cash Expenses) / 365 days
Is that right?
|Manu||Yes! Very much.|
|Vinu||What’s the formula for Basic Defence Interval Measure?|
|Manu||Basic Defence Interval Measure = Cash Resources available / Cash Expenses per day.|
|Vinu||Ya! I can understand.
So this ratio says, how long we can manage our cash expenses with available cash resources. Good. It is also a great tool for management for plan their cash flows.
|Vinu||Who will be basically using these Liquidity Ratios?|
|Manu||That’s a good question.
Lenders and Creditors would be checking these ratios of their customers or prospective customers. Because, they generally come under current liability category, and if these liquidity ratios are going to be weak, it’s a warning signal for them.
|Vinu||Yes! Yes! What are the other ratios to be discussed?|
|Manu||We have to cover
b) Capital Structure / Leverage Ratios
c) Activity Ratios
d) Profitability Ratio
|Vinu||Will do it now?|
It would become heavy now! Let’s take some time and do it little later.
|Vinu||Ok! Shall wait|