Current assets mean assets that can be converted in to cash quickly. Current liabilities mean liabilities payable at a short notice. An ideal current ratio is 2. The ratio of 2 is considered as a safe margin of solvency due to the fact that if the current assets are reduced to half, i.e. 1 instead of 2, then also the creditors will be able to get their payments in full. At the same time a very high current ratio is not desirable since it means less efficient use of funds.
The quick ratio is similar to the current assets that are computed as current assets minus inventories. This of course provides a better view of a firm’s liquidity and is useful in case of firms having a high proportion of obsolete or slow moving item:
Quick ratio = Current assets – Inventory / Current Liabilities
Leverage ratios: Leverage ratio identifies the source of a firm’s capital — owners or outside creditors. Financial leverage refers to the debt in financing non current assets. If the return on assets exceeds the cost of debt, the leverage is successful – i.e. it improves return on equity.
The debt to equity ratio is applicable to firms, which use debt as a means of financing. It is calculated by dividing long term, debt. One can take equity ratio as quite satisfactory if shareholders’ funds are equal to borrowed funds. However, excessive liabilities tend to cause insolvency. The ratio shows the extent to which the firm depends upon outsiders for its existence.
Debt Equity ratio = Total long term Debt / Shareholder’s Funds
Interests coverage ratio = Earnings before Interest & taxes (EBIT) / Interest
A firm with a high debt equity ratio interest (say more than 2:1) and a low interest coverage ratio (say less than 2) is perceived to have a high degree of financial risk. Another ratio called proprietary ratio is a variant of debt ratio. It establishes the relationship between the shareholder’s funds and the total assets. It may be expressed as:
Proprietary ratio = Shareholders Funds / Total assets
A high proprietary ratio is a source of strength to creditors (since assets are more than sufficient to meet obligations toward creditors) The debt to assets ratio indicates the extent to which the borrowed funds have been used to finance a firm’s operations.
Debt to Assets ratio = Total debts / Total assets
Leverage ratios, thus indicate the firm’s ability to meet its long term obligations. Higher the gearing ratio, higher is the risk since a large portion of the firm’s earnings goes towards the fixed interest charges payable to creditors
Activity ratios: They are primarily used for studying a firm’s working capital situation. A well managed firm should have good activity ratios:
1) The asset turnover ratio indicates how efficiently management is employing total assets.
Assets Turnover ratio = Sales / Total assets
2) The Fixed assets turnover ratio indicates the extent to which the investments in fixed assets is on sales
Fixed assets turnover ratio = Sales (net) / net fixed assets
3) The working capital turnover ratio indicates whether or not working capital has been effectively used in making sales.
Working Capital Turnover ratio = Sales (net) / working capital
4) The Debtors Turnover ratio indicates the efficiency of staff entrusted with collection of book debts. A higher ratio shows that debts are collected promptly
5) The Inventory Turnover ratio reveals the effectiveness of a firm’s inventory management. Higher sales turnover achieved with relatively lower inventory is a desirable situation/. The Japanese have mastered this art by what they call just in time inventory management.
Inventory Turnover ratio = Cost of Goods sold / Inventory
Source: Strategic Management