Types of Ratios

Types of Ratios

Ratios can be classified into four broad groups: (i) Liquidity ratios, (ii) Capital structureneverage ratios, (iii) Profitability ratios, and (iv) Activity ratios.

Liquidity Ratios

The importance of adequate liquidity in the sense of the ability of a firm to meet current/short-term obligations when they become due for payment can hardly be overstressed. In fact, liquidity is a prerequisite for the very survival of a firm. The short-term creditors of the firm are interested in the short-term solvency or liquidity of a firm. But liquidity implies, from the viewpoint of utilization of the funds of the firm, that funds are idle or they earn very little. A proper balance between the two contradictory requirements, that is, liquidity and profitability, is required for efficient financial management. The liquidity ratios measure the ability of a firm to meet its short-term obligations and reflect the short-term financial strength/solvency of a firm. The ratios which indicate the liquidity of a firm are: (i) networking capital, (ii) current ratios, (iii) acid test/quick ratios, (iv) super quick ratios, (v) turnover ratios, and-(.vi) defensive-interval ratios.

Net Working Capital

Net working capital (NWC) represents the excess of current assets over current liabilities. The term current assets refers to assets which in the normal course of business get converted into cash without diminution in value over a short period, usually not exceeding one year or length of operating cash cycle whichever is more. Current liabilities are those liabilities, which at the inception are required to be paid in short period, normally a year. Although NWC is really not a ratio, it is frequently employed as a ― measure of a company‘s liquidity position. An enterprise should have sufficient NWC in order to be able to meet the claims of the creditors and the day-to-day needs of business. The greater is the amount of NWC, : the greater is the liquidity of the firm. Accordingly, NWC is a measure of liquidity. Inadequate working capital is the first sign of financial problems for a firm.

Current Ratio

The current ratio is the ratio of total current assets to total current liabilities. It is calculated by dividing current assets by current liabilities:
Current ratio = Current assets/current liabilities
The current assets of a firm, as already stated, represent those assets which can be, in the ordinary course of business, converted into cash within a short period of time, normally not  xceeding one year and include cash and bank balances, marketable securities, inventory of raw materials, semi-finished (work-inprogress) and finished goods, debtors net of provision for bad and doubtful debts, bills receivable and prepaid expenses. The current liabilities defined as liabilities which are short-term maturing obligations to be met, as originally  on templated, within a year, consist of trade creditors, bills payable, bank credit, provision for taxation, dividends payable and outstanding expenses.

Rationale

The current ratio of a firm measures its short-term solvency, that is, its ability to meet short-term obligations. As a measure of short-term/current financial liquidity, it indicates the rupees of current assets available for each rupee of current liability obligation. The higher the current ratio, the larger is the amount of rupees available per rupee of current liability, the more is the firm‘s ability to meet current obligations and the greater is the safety of funds of short-term creditors. Thus, current ratio, in away, is a measure of margin of safety to the creditors
The need for safety margin arises from the inevitable unevenness in the flow of funds through the current assets and liabilities account. If the flows were absolutely smooth and uniform each day so that inflows exactly equaled absolutely maturing obligations, the requirement of a safety margin would be small. The fact that a firm can rarely count on such an even flow requires that the size of the current assets should be sufficiently larger than current liabilities so that the firm would be assured of being able to pay its current maturing debt as and when it becomes due. Moreover, only making payment whereas the current assets available to liquidate them are subject to shrinkage for various reasons, such as bad debts, inventories becoming obsolete or unsaleable and occurrence of unexpected losses in can settle the current liabilities marketable securities and so on. The current ratio measures the size of the short-term liquidity buffer‘. A satisfactory current ratio would enable a firm to meet its obligations even when the value of the current assets declines.