All about Liquidity Ratio and its Calculation | ApnaCourse

by | Nov 10, 2016 | Financial Management

 Manu

Conversation Between

Vinu

 1

 Manu and Vinu about
Liquidity Ratio

 2
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

loans.

Manu Ok
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

said

– 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???

Manu Ohhh…!!!
Vinu I was wondering how they can say all these in just 5-10 minutes just by reading Balance

Sheet?

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!!!
Vinu What?
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,

Disclosures, etc.

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

– Efficiency;

– Cash generating capacity;

– Profitability;

– Liquidity;

– Solvency;

– 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;

-Litigations;

-Future directions;

Vinu OMG!!!
Manu Yes Vinu!

You know, there is a saying called “Face is the Index of the Mind”

In case of Business Entities, Balance Sheet is their Face.

Vinu Agreed!

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.

Vinu Skill?
Manu Yes! Balance Sheet reading is a skill which any one can develop through practice.
Vinu Oh…
Manu There are various Financial Ratios which will help you to read the Balance Sheet.
Vinu Is it?
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?
Vinu 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.

Vinu Ok.
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.

Manu Fair enough…

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.

Particulars A Ltd B Ltd
Sales 100 Cr 20 Crs
Profit 10 Cr 5 Cr

I think I should change my mind.

Manu Why?
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

Particulars A ltd B Ltd
a)      Sales 100 Cr 20 Crs
b)      Profit 10 Cr 5 Cr
c)       Profit Margin (b/a) x 100 10% 25%
Manu Perfect.

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.

Vinu True!
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.

Vinu Ok.
Manu Broadly ratios can be categorised into four categories.
Vinu Ok
Manu They are

a)      Liquidity Ratios;

b)      Capital Structure / Leverage Ratios;

c)       Activity Ratios;

d)      Profitability Ratios.

Vinu Ok.
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!
Vinu Liquidity means?
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)

Vinu Ok..ok..Understood!
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!!!
Manu True Vinu!

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.

Vinu Ok.
Manu Do you know, how they arranged this Rs.75 Crs?
Vinu You have to tell meJ
Manu
Bank Term Loan Rs. 50 Crs
Promoters Capital Contribution Rs. 23 Crs
Short Term Loan (repayable within 1 Year) Rs. 2 Crs
Vinu Ok
Manu The grave mistake done by the company is arranging Rs.2 Crs of Short Term Funds for

funding their long term project.

Vinu Why?
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.
Vinu My God!
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.
Vinu Ok.
Manu They are

a)      Current Ratio

b)      Quick Ratio

c)       Cash Ratio

d)      Defence Interval Ratio

Vinu Current Ratio we have already discussed.
Manu Yes Vinu.

It will be available in this link

http://www.caclubindia.com/articles/analysis-on-current-ratio-

23048.asp#.VTc860a7jYk

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

Current Ratio.

The answer is “Quick Ratio is an extension of Current Ratio”.

Sometimes, mere dependence of current ratio will be misleading.

Vinu Why?
Manu Let’s say, you have current asset of Rs.100 Crs and Current Liability of Rs.50 Crs.
Vinu Ok
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!

Current Liabilities Current Assets
Sundry Creditors (Supplies) 50.00 Inventory 75.00
Receivables 15.00
Cash and Bank Balances 10.00
Vinu What’s wrong in this?
Manu You have to pay Rs.50 Crs to Sundry Creditors. i.e., your suppliers – right?
Vinu Yes!
Manu What are the resources you have?
Vinu
Inventory 75.00
Receivables 15.00
Cash and Bank Balances 10.00
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.
Vinu Yes.
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.
Vinu Yes!
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.
Vinu True.
Manu But many of your current liabilities may be quick liabilities. Though not separated.
Vinu Ok!
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.
Vinu Ok.
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
Manu Good.
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.

Vinu Quick Liabilities?
Manu Yes! Out of Current liabilities, certain liabilities may not be quick. They are almost permanent liabilities.
Vinu Like?
Manu Like Bank Overdraft / Cash Credit?
Vinu Really?
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.
Vinu Ok!
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

Manu Yes!

We shall move on to the next ratio.

It is Absolute Liquidity Ratio.

Vinu Ok.
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?
Vinu Ok.
Manu In such cases, you cannot expect stock and receivables to convert into cash immediately.
Vinu  Ya.
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.

Vinu Ok.
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.
Vinu Yes!
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.
Vinu Like?
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.

Manu Yes Vinu.
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?
Manu No Vinu!

It would become heavy now! Let’s take some time and do it little later.

Vinu Ok! Shall wait
N Raja CA, A Practicing Chartered Accountant with tonnes of passion for teaching. He also holds a PGDBA – Finance from Symbiosis SCDL and a B.Com., from Loyola College, Chennai. Read More.

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