Question

Financial ratio question - Interpretation 1

1. Current Ratio: How does the quick ratio differ from the current ratio?
2. Days in inventory [inventory age] : what is relationship between Inventory age [ inventory / ( Annual COGS/365)]   and the “ Liquidity condition”
3. Inventory Turnover [COGS/inventory]: given its relation to inventory age, why use COGS instead of Sales?
4. Day In Receivables [average collection Period ] = A/Rs / (annual Credit Sales /365)
   1. Why only credit sales are included in calculating this ratio?
   2. How does this ratio speak to the “liquidity condition”?
5. Account receivable turnover [Annual Credit Sales / {A/R} ]: This larger ratio, the better is the firm’s liquidity condition?
   
   

Answer 1

Current ratio =Current assets/Current liabilities.

Current assets are those which can be converted into cash in a short period of time usually not mre than a year.

Current assets=cash,bank balances,marketable securities,inventory of raw materials,semi finished and finished goodsbills receivable, provision for bad and doubtful debts,prepaid expenses.

Current liabilities is short term payment to be made.

Current Liabilities=bills payable, bank credit,provision for tax,dividends payable,outstanding expenses,creditors.

Quick ratio=Current assets-inventory-repaid expenses/Current liabilities.

It is widely accepted liquidity measure.The difference between current ratio and quick ratio is exclusion of prepaid expenses and inventory.The exclusion of inventory is because it is not easily coverted to cash and prepaid expenses because the amount is not available to pay off debt and just reduction in the expenses.It is called as quick because it is a measurement of firm's ability to convert into cash quickly.Current ratio of 2:1 is considered satisfactory whereas quick ratio of 1:1 is considered better for the firm.

Days in inventory and liquidity=A higher ratio is not good from the view point of liquidity and lower is better.Lower is better because it means that the stocks are selling soon and getting converted to liquid cash.

Inventory turnover=COGS/Inventory=Sales-gross profit/Inventory

It means how fast the inventory is selling to recover the cost in making those goods.So higher the ratio better for the liquidity.It is inverse of Days in inventory ratio.Cost of good sold is the cost incurred and is not sales.

Days in receivables=annual credit /365

a)Credit sales consist of gross credit sales - returns, if any from customers.It is how fast receivables are collected.It is the time lag between credit sales and cash collection.Lesser the number of days better for the firm as it means money is getting collected faster.Only credit is taken because company would have not sold all goods on cash basis so if we include sales instead off credit would give us a wrong calculation as the company would have not got money and its accrued income.

b)Liquidity condition=Lesser the number of days better is the liquidity and vice versa as explained above.

Account receivable =Annual credit sales/Average Debtors.

A larger ratio means that shorter is the time lag between credit sales and cash collection.It measures how fast receivables are collected.