Financial Ratios – Chapter 1

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Liquidity Ratios: Liquidity ratios give information regarding a firm’s ability to meet the short term obligations as and when they come due. Simply put, liquidity ratios gauge the ability of firm to convert its current assets into cash to meet short term obligations.

What information do we get from Liquidity Ratios? Since liquidity ratios gives insight on firm’s ability to meet short term obligations; So these ratios can impact a company’s credibility or credit ratings while applying for new loans. If company is not able to meet short term obligations and defaulting on payments then very highly likely that company might be heading for bankruptcy. Hence, these ratios give very insightful information regarding company’s working capital and management along with chances of company being solvent in long term.

Use of Liquidity Ratios: Liquidity ratios are used while doing within company or across companies’ comparisons. While within company comparison is done over several accounting period; whereas across different company comparison is done to compare a company’s ratios with industry standards.

There are three import Liquidity Ratios an analyst looks into:

  1. Current Ratio
  2. Acid Test or Quick Ratio
  3. Absolute Liquidity or Cash Ratio

Current Ratio:  Analyzing the current ratio is the first step into liquidity ratio analysis. This ratio attempts to measure the relation between current asset and current liabilities accordingly the name given. Note that this formula considers all current assets and current liabilities. Current assets are those assets that are expected to turn into cash within one year.

Current Ratio = Current Assets/Current Liabilities

Where,

Current Assets: Stock, Debtor, Cash and bank, receivables, loan and advances, and other current assets.

Current Liability: Creditor, Short-term loan, bank overdraft, outstanding expenses, and other current liability.

Higher the current ratio higher the chances that company will be able to payback its liabilities. Current ratio of less than 1 indicates negative working capital; where

Working Capital = Current Assets – Current Liabilities

Below is the comparison of ratios for few Indian Banks:

Mar ’18 Mar ’17 Mar ’16 Mar ’15 Mar ’14
HDFC Bank 0.04 0.06 0.07 0.04 0.06
ICICI Bank 0.12 0.12 0.13 0.06 0.09
Yes Bank 0.07 0.08 0.08 0.06 0.08
SBI 0.08 0.07 0.07 0.04 0.03

Data Source Money Control.

Looking into above table we could make 2 inferences:

  1. Current ratio is more or less stable across periods for each bank. Which means there is nothing unusual happened across banks in like each bank should have very stable growth of deposits along with loan given out.
  2. ICICI bank has the highest current ratio in comparison to other banks which needs further analysis of balance sheet and income statement.

Quick Ratio (Acid Test): Quick ratio is more stringent in comparison to current ratio as it does not include inventories or other assets that might take time to convert into cash. The purpose of this ratio is to measure how well a company can meet its short-term obligations with its most liquid assets.

Acid Ratio = (Cash & Cash Equivalents + Short-Term Investments + Accounts Receivable) ÷ Current Liabilities  

Cash and cash equivalents refer to such things as cash in hand, checking accounts, savings accounts, and money market accounts. Short-term investments are any investments that will mature within 90 days.

Higher the acid ratio higher is the probability that a firm should be able to meet short term obligations.

Below is the comparison of ratios for few Indian Banks:

Mar ’18 Mar ’17 Mar ’16 Mar ’15 Mar ’14
HDFC Bank 17.48 11.19 14.51 12.69 8.55
ICICI Bank 3.57 3.55 3.91 3.5 3.56
Yes Bank 20.69 13.14 13.99 12.25 10.4
SBI 13.83 11.94 10.84 10.78 13.81

 

If we compare Current ratios and Quick Ratios we could realize that while current ratio for ICICI bank was quite high in comparison to other banks but order totally reverse for quick ratios.

Absolute liquidity ratio: The most conservative measure of liquidity is absolute liquidity ratio. Absolute Liquid Assets take into account cash in hand, cash at bank, and marketable securities or temporary investments. The most favorable and optimum value for this ratio should be 1: 2. It indicates the adequacy of the 50% worth absolute liquid assets to pay the 100% worth current liabilities in time.

Note: Due to unavailability of data we could not do not comparison across banks or over the period.

Important Note: Though ratios greatly helps in analyzing the financial health of a firm but standalone ratio could give wrong interpretation of financial activities. Before coming to any conclusion we need study a set of ratios along with balance sheet before making any investment decision.

Next section would cover Leverage Ratios.

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