MODEL ANSWER TO TO JUDGE THE LIQUIDITY POSITION OF THE FIRM

 QUESTION EXPLAIN THE VARIOUS RATIOS WHICH ARE HELPFUL TO JUDGE THE LIQUIDITY POSITION OF A FIRM?
ACCOUNTING FOR MGMT DECISIONS

´  RATIO ANALYSIS

´  MEANING OF RATIO

´  A RATIO IS A SIMPLE ARITHMETICAL EXPRESSION OF THE RELATIONSHIP OF ONE NUMBER TO ANOTHER. ACCORDING TO KELL AND BEDFORD ,” IS AN EXPRESSION OF  QUANTITATIVE RELATIONSHIP BETWEEN TWO NUMBERS.” RATIOS CAN BE EXPRESSED IN PERCENTAGE, TIMES ETC

´  CURRENT ASSETS =200000

´  CURRENT LIABILITY = 100000

´  RATIO OF CURRENT ASSETS/CURRENT LIABILITIES =2

´  OR IT COULD BE 2:1 OR 200% OR 2/1

´  IT IS A TECHNIQUE OF ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS. IT IS THE PROCESS OF ESTABLISHING AND INTERPRETING VARIOUS RATIOS FOR HELPING IN MAKING CERTAIN DECISIONS.

´  STEPS:-

I.        SELECTION OF RELEVANT DATA

II.        CALCULATION

III.        COMPARISON

IV.        INTERPRETATION

´  ANALYSIS OF SHORT TERM FINANCIAL POSITION OR JUDGMENT OF LIQUIDITY

A FIRM MUST ENSURE THAT IT DOES NOT SUFFER FROM LACK OF LIQUIDITY OR THE CAPACITY TO PAY ITS CURRENT OBLIGATIONS WHEN THEY BECOME DUE. IF A FIRM FAILS TO MEET SUCH CURRENT OBLIGATIONS DUE TO LACK OF POOR LIQUIDITY POSITION,ITS IMAGE WILL BE AFFECTED ADVERSELY. IT WILL RESULT IN POOR CONFIDENCE OF THE CREDITORS IN THE FIRM AND FIRM WILL NOT BE ABLE TO RUN THE BUSINESS.

EVEN HIGH DEGREE OF LIQUIDITY IS NOT GOOD FOR A FIRM. IT MEANS THE FIRM IS NOT UTILIZING THE FUNDS PROPERLY. SO THERE SHOULD BE PROPER BALANCE IN REGARD TO THE LIQUIDITY OF THE FIRM.

THE FOLLOWING RATIOS ARE CALCULATED TO MEASURE THE SHORT TERM SOLVENCY OF THE FIRM:

LIQUIDITY RATIO

CURRENT ASSETS MOVEMENT OR EFFICIENCY RATIO

LIQUIDITY RATIOS

ABILITY OF A CONCERN TO MEET ITS CURRENT OBLIGATION AND AS AND WHEN THESE BECOME DUE.  THE SHORT TERM OBLIGATION ARE MET BY REALIZING AMOUNT FROM CURRENT, FLOATING OR CIRCULATING ASSETS.

THE FOLLOWING RATIOS :-

CURRENT RATIO

QUICK OR ACID TEST OR LIQUID RATIO

ABSOLUTE LIQUID RATIO

MEANING OF CURRENT RATIO

MAY BE DEFINED AS THE RELATIONSHIP BETWEEN CURRENT ASSETS AND CURRENT LIABILITIES. THIS RATIO IS ALSO KNOWN AS WORKING CAPITAL RATIO. IT IS A MEASURE OF GENERAL LIQUIDITY AND USED TO MEASURE THE SHORT TERM LIQUIDITY OF THE FIRM

CURRENT RATIO = CA/CL

RULE OF THUMB :- 2:1

´  COMPONENT OF CURRENT RATIO

CURRENT ASSETS

I.        CASH IN HAND

II.        CASH AT BANK

III.        SHORT TERM SECURITIES

IV.        SHORT TERM INVESTMENTS

V.        BILL RECEIVABLES

VI.        SUNDRY DEBTORS

VII.        STOCK

VIII.        PREPAID EXPENSES

´  CURRENT LIABILITIES

a.    OUT STANDING EXPENSES

b.    BILLS PAYABLE

c.    SUNDRY CREDITORS

d.    SHORT TERM LOAN

e.    INCOME TAX PAYABLE

f.      DIVIDEND PAYABLE

g.    BANK OVERDRAFT IF IT IS NOT PERMANENT ARRANGEMENT

´  CURRENT RATIO

´  HIGH CURRENT RATIO MAY NOT BE FAVORABLE:-

a.    SLOW MOVING STOCK

b.    IDLE CASH BALANCES

c.    DEBT COLLECTION NOT SATISFACTORY

´     LOW CURRENT RATIO

a.    NOT SUFFICIENT FUNDS

b.    TRADING BEHIND CAPACITY

´  LIQUID RATIO ( QUICK OR ACID)

• IS MORE RIGOROUS TEST OF LIQUIDITY THAN THE CURRENT RATIO. QUICK RATIO MAY BE DEFINED AS THE RELATIONSHIP BETWEEN QUICK ASSETS AND CURRENT LIABILITIES. CURRENT ASSETS INCLUDE INVENTORIES AND PREPAID EXPENSES WHICH ARE NOT EASILY CONVERTED INTO CASH. SO QUICK ASSETS ARE CURRENT ASSETS MINUS STOCK AND PREPAID EXPENSES

• LIQUID RATIO = QUICK ASSETS/CURRENT LIABILITIES
• RULE OF THUMB:-1:1. A HIGH ACID TEST RATIO IS AN INDICATION THAT THE FIRM IS LIQUID AND HAS THE ABILITY TO MEET ITS SHORT TERM OBLIGATIONS AND ON THE HAND LOW RATIO INDICATES FIRM’S LIQUIDITY POSITION IS NOT VERY GOOD.
• QUICK ASSETS = CA-STOCK –PREPAID EXPENSES

• ABSOLUTE LIQUID RATIO OR CASH RATIO
• ABSOLUTE RATIO SHOULD BE CALCULATED WITH CURRENT RATIO AND ACID TEST RATIO. ABSOLUTE LIQUID ASSETS :- CASH IN HAND+ CASH AT BANK +SHORT TERM SECURITIES
•  ABSOLUTE LIQUID ASSETS/CL
• RULE OF THUMB =.5 :1
• ABSOLUTE LIQUID RATIO = 5000/25,000 =.20 :1

• CURRENT ASSETS MOVEMENT/EFFICIENCY RATIO

• CONCERNED WITH MEASURING THE EFFICIENCY IN ASSETS MGMT
• TURNOVER MEANS ROTATION OR UTILIZATION OF RESOURCES OR AN ASSET IN THE PROCESS OF BUSINESS ACTIVITY.FUNDS ARE INVESTED IN VARIOUS ASSETS IN THE BUSINESS TO MAKE SALES AND EARN PROFIT. THE EFFICIENCY WITH WHICH ASSETS ARE MANAGED DIRECTLY AFTER THE VOLUME OF SALES. ACTIVITY RATIO MEASURES THE EFFICIENCY OR EFFECTIVENESS WITH WHICH A FIRM MANAGES RESOURCES OR ASSETS. THESE RATIOS ARE CALLED TRUNOVER RATIO.
• THE CURRENT RATIO AND THE ACID TEST RATIO GIVES MISLEADING RESULT DUE TO HIGH AMOUNT OF DEBTORS AND SLOW MOVING INVENTORIES.
• TYPES OF ACTIVITY RATIO

1. INVENTORY TURNOVER RATIO
2. DEBTOR TURNOVER RATIO
3. WORKING CAPITAL TURNOVER RATIO
4. CURRENT ASSETS TURNOVER RATIO
5. CREDITOR TURNOVER RATIO

• EXPLANATION OF ACTIVITY RATIOS
• INVENTORY RATIO ALSO  KNOWN AS STOCK VELOCITY RATIO. IT INDICATES THE NUMBER OF TIME THE STOCK HAS BEEN TURNED OVER DURING THE PERIOD AND EVALUATE THE EFFICIENCY WITH WHICH A FIRM IS ABLE TO MANAGE ITS INVENTORY.
• INVENTORY RATIO= COST OF GOODS SOLD/AVERAGE INVENTORY
• INVENTORY CONVERSION PERIOD IS CALCULATED FOR AVERAGE TIME TAKEN TO CLEAR THE STOCK.
• DEBTOR TURN OVER RATIO DEBTORS VELOCITY INDICATES THE NUMBER OF TIMES THE DEBTORS ARE TURNED OVER DURING A YEAR. GENERALLY HIGHER THE VALUE OF DEBTOR TURNOVER THE MORE EFFICIENT MANAGEMENT OF DEBTOR. TWO KINDS OF RATIO DEBTOR VELOCITY AND AVERAGE COLLECTION PERIOD IS CALCULATED 365 DIVIDED  BY DEBTOR TURNOVER RATIO. WHICH SHOWS THE PERIOD IN WHICH THE PAYMENT IS COLLECTED FROM THE DEBTORS. LOWER THE RATIO BETTER IT IS AND VICE VERSA.
•  
• CREDITORS /PAYABLE RATIO IS CALCULATED THE RELATION BETWEEN THE NET CREDIT ANNUAL PURCHASE DIVIDED BY AVERAGE CREDITORS.THE CREDITORS IS USUALLY INTERESTED IN FINDING OUT HOW MUCH TIME THE FIRM IS LIKELY TO TAKE IN REPAYING ITS TRADE CREDITORS.
• CREDITORS TURNOVER RATIO=NET CREDIT PURCHASE/AVERAGE TRADE CREDITORS
• THE RATIO INDICATES THE VELOCITY WITH WHICH CREDITORS ARE TURNED OVER IN RELATION TO PURCHASE. GENERALLY LOWER THE RATIO,THE BETTER IS THE LIQUIDITY POSITION OF THE FIRM AND HIGHER THE RATIO,LESS LIQUID IS THE POSITION OF THE FIRM.BUT A HIGHER PAYMENT PERIOD ALSO IMPLIES GREATER CREDIT PERIOD ENJOYED BY THE FIRM AND VICE VERSA
• WORKING CAPITAL TURNOVER RATIO INDICATES THE VELOCITY OF UTILIZATION OF NET WORKING CAPITAL. THIS RATIO INDICATES THE NUMBER OF TIMES THE WORKING CAPITAL IS BEING USED BY FIRM. A HIGHER RATIO INDICATES THE EFFICIENT UTILIZATION OR VICE VERSA
• WORKING CAPITAL TURNOVER RATIO MEANS=COST OF SALES/AVERAGE WORKING CAPITAL