Ratio Analysis: Liquidity and Solvency Ratios

  • Accounting ratios define the relationship between selected financial data that can be expressed as percentages, rates, proportions or fractions.
  • The objectives of ratio analysis are to locate weak spots of business, provide information for making cross-sectional analysis and time series analysis, etc. factors to be considered while undertaking cross sectional analysis are quality of financial statements, purpose of analysis, selection of ratios, etc.
  • Ratios help in the analysis of Financial Statements, comparative study, understanding efficiency of operations, forecasting, fixing ideal standards, studying financial soundness, etc.
  • Limitations of accounting ratios are that they are quantitative in nature, lack ability to solve a problem, external factors not reflected in accounts; they are based on unrelated figures, window dressing, different price levels, etc.
  • On the basis of statement, ratios can be classified as Balance Sheet Ratios such as Current Ratio, Quick ratio, Debt- Equity Ratio, etc., Statement of Profit & Loss Ratios such as Gross Profit Ratios, Net Profit ratios, Operating profit Ratios, etc., and Composite ratios such as Trade Receivable Ratios, Trade Payables Ratios, Inventory Ratios, etc. On the basis of usability, the ratios can be Liquidity Ratios, Solvency Ratios, Turnover Ratios and Profitability Ratios, Liquidity ratios show the ability of the firm to pay its obligations.
  • Liquidity ratios show the ability of the firm to pay its short term obligations. Current Ratio show whether the business has sufficient current assets to pay off current liabilities.
  • Quick ratio or Acid test ratio or liquid ratio shows whether the business has sufficient quick/ liquid assets to pay off current liabilities.
  • Solvency ratio measures the ability of the enterprise to meet its long term obligations on due date.
  • Debt-equity ratio,total assets to debt ratio, proprietary ratio and interest coverage ratio are solvency ratios. Debt-equity ratio assesses the soundness of long term financial position of the firm.
  • Total assets to debt ratio measures the safety margin available to providers of long term debts.
  • Proprietary ratio highlights the general financial position of the firm.
  • Interest coverage ratio establishes relationship between net profit before interest and tax and interest payable on long term debts.

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  • Q1

    The current ratio is 3:1. Sundry creditors of ₹ 1,00,000 are paid in cash. As a result of this change, the working capital will

    Marks:1
    Answer:

    remain same.

    Explanation:

    If one item of current assets and one item of current liabilities increase or decrease, the working capital will not change.

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  • Q2

    An ideal quick ratio is

    Marks:1
    Answer:

    1 : 1.

    Explanation:
    An ideal quick ratio is 1:1. The ideal means that for every rupee of current liablities, there should atleast be one rupee of liquid assets.
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  • Q3

    Current ratio is 2:1, when working capital is ₹ 1,00,000, current liabilities will be

    Marks:1
    Answer:

    ₹ 1,00,000

    Explanation:

    Let current liabilities = x; Working capital = Current assets - current liabilities ; 1,00,000 = 2x - x ; x (current liabilities) = ₹ 1,00,000.

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  • Q4

    The two basic measures of liquidity are

    Marks:1
    Answer:

    Current ratio and liquid ratio

    Explanation:

    The two basic measures of liquidity are current ratio and  liquid ratio.

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  • Q5

    Acid-test ratio =

    Marks:1
    Answer:

    Quick assets / current liabilities

    Explanation:
    Acid-test ratio = Quick assets / current liabilities It is also called quick ratio or liquid ratio. It is the measure of short term financial solvency of business.
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