Liquidity ratios are used in financial analysis to determine whether a company is able to pay off its short-term debt obligations and manage its working capital requirements.
Higher the value of these ratios the larger the margin of safety. Although the equation used for calculating these ratios is same, but the value we get may be good or bad depending on many variables.
These variables are size of the business, the sector in which the business is operating, the amount and type of the inventory, and the customer base.
CURRENT RATIO
This term expresses current assets in relation to current liabilities (current ratio = current assets/current liabilities). Current assets are expected to be sold or otherwise realised in cash within one year or one operating cycle of the business. It includes cash, accounts receivable, inventory, marketable securities, prepaid expenses and other liquid assets that can be readily converted to cash. Companies’ operating cycle is the average amount of time that elapses between acquiring materials and collecting cash from the sales to customers. Similarly, liabilities expected to be settled within one year or within one operating cycle of the business, whichever is greater is classified as current liabilities. Therefore, if current assets are greater than current liabilities (i.e. current ratio > 1), indicates that the company has a higher level of liquidity i.e. greater ability to meet short-term obligations. A lower ratio indicates less liquidity implying that the company relies more on operating cash flow and outside financing to meet short term obligations. Companies such as Hindustan Zinc and National Mineral Development Corporation (NMDC) have a very high current ratio of 13.9 and 10.12 respectively. On the other side, Jet airways, telecom major Bharti Airtel and Idea cellular have a current ratio of around 0.3.
QUICK RATIO
Quick ratio is more conservative than the current ratio as it excludes inventory from current ratio. Inventory cannot be easily and quickly converted into cash. The company would probably not be able to sell its entire inventory for an amount equal to its book value or carrying value. Like the current ratio, higher quick ratio indicates greater liquidity. Hindustan Zinc and NMDC have a quick ratio of 13 and 9.3. Jet and Idea have a quick ratio of 0.1, while the figure for Bharti Airtel is 0.2.
CASH RATIO
It is the ratio of total cash and cash equivalents to current liabilities. Cash equivalents are short-term marketable securities which can be easily sold. Cash ratio is the most stringent and conservative liquidity ratio. Interestingly, in the BSE 200 index (excluding banks) only 16 per cent of the companies had a cash ratio of greater than 1.
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