Liquidity ratios asses a businesss liquidity, i.e. its ability to convert its assets to cash and pay off
its obligations without any significant difficulty (i.e. delay or loss of value). Liquidity ratios are
particularly useful for suppliers, employees, banks, etc. Important liquidity ratios are:
Current Ratio
Current ratio is one of the most fundamental liquidity ratio. It measures the ability of a business
to repay current liabilities with current assets.
Formula
Current ratio is calculated using the following formula:
Current Assets
Current Ratio =
Current Liabilities
Quick Ratio
Quick ratio is most useful where the proportion of illiquid current assets to total current assets is
high. However, quick ratio is less conservative than cash ratio, another important liquidity
parameter.
Formula
The following is the most common formula used to calculate quick ratio:
Cash + Marketable Securities + Receivables
Quick Ratio
Current Liabilities
Cash Ratio
Cash ratio is the ratio of cash and cash equivalents of a company to its current liabilities. It is an
extreme liquidity ratio since only cash and cash equivalents are compared with the current
liabilities. It measures the ability of a business to repay its current liabilities by only using its
cash and cash equivalents and nothing else.
Formula
Cash ratio is calculated using the following formula:
Cash + Cash Equivalents
Cash Ratio =
Current Liabilities
Cash equivalents are assets which can be converted into cash quickly whereas current liabilities
are those liabilities which are to be settled within 12 months or the business cycle.
Activity Ratios
Activity ratios assess the efficiency of operations of a business. For example, these ratios attempt
to find out how effectively the business is converting inventories into sales and sales into cash, or
how it is utilizing its fixed assets and working capital, etc. Key activity ratios are:
Average collection period is computed by dividing the number of working days for a given
period (usually an accounting year) by receivables turnover ratio. It is expressed in days and is
an indication of the quality of receivables.
PROFITABILITY RATIOS
Profitability ratios are a class of financial metrics that are used to assess a business's ability to
generate earnings compared to its expenses and other relevant costs incurred during a specific
period of time. For most of these ratios, having a higher value relative to a competitor's ratio or
relative to the same ratio from a previous period indicates that the company is doing well.
Net profit is not an indicator of cash flows, since net profit incorporates a number of non-cash
expenses, such as accrued expenses, amortization, and depreciation.
The formula for the net profit ratio is to divide net profit by net sales, and then multiply by 100.
The formula is:
DEBT-EQUITY RATIO
Debt/Equity Ratio is a debt ratio used to measure a company's financial leverage, calculated by
dividing a companys total liabilities by its stockholders' equity. The D/E ratio indicates how
much debt a company is using to finance its assets relative to the amount of value represented in
shareholders equity.
The formula is:
DEBT-EQUITY RATIO= LOANS /SHAREHOLDERS FUND