Well aruna! Financial ratio is a quantitative relationship between two items/variables. Financial ratios can be broadly classified into three groups: (I) Liquidity ratios, (II) Leverage/Capital structure ratio, and (III) Profitability ratios.
(I) Liquidity ratios
Liquidity refers to the ability of a firm to meet its financial obligations in the short-term which is less than a year. Certain ratios which indicate the liquidity of a firm are:
(i) Current Ratio, (ii) Acid Test Ratio, (iii) Turnover Ratios. It is based upon the relationship between current assets and current liabilities.
(i) Current ratio =
Current Liabilitie s
Current Assets
.
.
The current ratio measures the ability of the firm to meet its current liabilities from the current assets. Higher the current ratio, greater the short-term solvency (i.e. larger is the amount of rupees available per rupee of liability).
(ii) Acid-test Ratio =
Current Liabilitie s
Quick Assets
.
.
Quick assets are defined as current assets excluding inventories and prepaid expenses. The acid-test ratio is a measurement of firm’s ability to convert its current assets quickly into cash in order to meet its current liabilities. Generally speaking 1:1 ratio is considered to be satisfactory.
(iii) Turnover Ratios:
Turnover ratios measure how quickly certain current assets are converted into cash or how efficiently the assets are employed by a firm. The important turnover ratios are:
-Inventory Turnover Ratio,
-Debtors Turnover Ratio,
-Average Collection Period,
-Fixed Assets Turnover and
-Total Assets Turnover
Inventory Turnover Ratio =
Average Inventoty
Cost of Goods Sold
Where, the cost of goods sold means sales minus gross profit. ‘Average Inventory’ refers to simple average of opening and closing inventory. The inventory turnover ratio tells the efficiency of inventory management. Higher the ratio, more the efficient of inventory management.
Debtors’ Turnover Ratio =
AverageAccountsRe ceivable(Debtors)
NetCreditSales
The ratio shows how many times accounts receivable (debtors) turn over during the year. If the figure for net credit sales is not available, then net sales figure is to be used. Higher the debtors turnover, the greater the efficiency of credit management.
Average Collection Period =
AverageDailyCreditSales
AverageD ebtors
Average Collection Period represents the number of days’ worth credit sales that is locked in debtors (accounts receivable). Please note that the Average Collection Period and the Accounts Receivable (Debtors) Turnover are related as follows:
Average Collection Period =
DebtorsTurnover
365 Days
Fixed Assets turnover ratio measures sales per rupee of investme nt in fixed assets. In other words, how efficiently fixed assets are employed. Higher ratio is preferred. It is calculated as follows:
Fixed Assets turnover ratio =
NetFixedAssets
Net.Sales
Total Assets turnover ratio measures how efficiently all types of assets are employed.
Total Assets turnover ratio =
AverageTotalAssets
Net.Sales
( II) Leverage/Capital structure ratios
Long term financial strength or soundness of a firm is measured in terms of its ability to pay interest regularly or repay principal on due dates or at the time of maturity. Such long term solvency of a firm can be judged by using leverage or capital structure ratios. Broadly there are two sets of ratios: First, the ratios based on the relationship between borrowed funds and owner’s capital which are computed from the balance sheet. Some such ratios are: Debt to Equity and Debt to Asset ratios. The second set of ratios which are calculated from Profit and Loss Account are: The interest coverage ratio and debt service coverage ratio are coverage ratio for leverage risk.
(i) Debt-Equity ratio reflects relative contributions of creditors and o
Answered by
Kumaar
at
5:43 PM on October 20, 2008
