Traditionally ratios are classified based on statement/s used
i. Balance Sheet Ratios
ii. Profit & Loss a/c Ratios
iii. Composite or Mixed or Inter-statement ratios
However, Functional Classification leads to a more meaningful discussion, understanding and analysis
i. Liquidity Ratios
ii. Activity or Efficiency or Performance or Turnover Ratios
iii. Profitability Ratios
iv. Leverage or Solvency / Capital Structure Ratios
Liquidity Ratios measure the ability of the firm to meet current / short-term obligations. They establish a relationship between cash and other current assets to current obligations. A firm
should strike a proper balance between high liquidity with more cash balance (which means less profitability) and low liquidity (with problems of failure to meet obligations etc.) Liquidity Ratios include (i) Current Ratio, (ii) Liquid or Acid Test Ratio or Quick Ratio, (iii) Cash Ratio or Absolute Liquid Ratio, (iv) Defensive-interval Ratio
a. Current Ratio: Current Ratio establishes relationship between the current assets and current liabilities and measures the ability of the firm to meet current liabilities.
Current Ratio = Current Assets/Current Liabilities
This ratio indicates the rupees of current assets available for each rupee of current liability / obligation. The higher the ratio, larger is the ability to meet current obligations and greater is the safety of funds of short-term creditors. Depending upon the industry the ratio may vary between 1.5 to 3.5 though the rule of thumb is 2.
b. Liquid Ratio or Acid Test Ratio or Quick Ratio: Liquid Ratio measures the ability to meet the current liabilities from the current assets which are readily or quickly convertible into cash (Current Assets less Inventory & Pre-paid expenses). Inventory is not readily convertible into cash and hence to be excluded.
Liquid Ratio = Liquid or Quick Assets/Current Liabilities
It is called Acid Test Ratio since it is more severe and stringent test. Rule of thumb is 1.
c. Cash Ratio / Absolute Liquid Ratio: Absolute Liquid Assets are considered here. Receivables have doubts about their realisability in time and hence they are excluded here.
Cash Ratio=Cash & Bank Balances + Marketable Securities/Current Liabilities
d. Defensive-internal Ratio
This ratio measures the ability to meet projected daily operating expenditure
Defensive-internal Ratio= Liquid Assets/Projected daily cash requirements
Projected Cash Operating Expenditure may be ascertained by adding Cost of goods sold + Selling & administrative and other cash expenses less depreciation & other non-cash expenditure. The resultant figure will be in number of days.