Question

An investor wants to tests the financial position of ABC Inc. Thus, he wants to assess the short term liquidity as well as long term solvency. Discuss the four relevant ratio’s which he will definitely look into

Answer 1

Relevant ratios are as below:

No.1) Current ratio: This is the ratio of total current assets to total current liabilities; (Total current assets / Total current liabilities). Total current assets must be higher than total current liabilities, if the company has short-term liquidity.

No.2) Quick ratio: This is the ratio of total current assets except inventory to total current liabilities; [(Total current assets – Inventory) / Total current liabilities]. Here also the numerator must be higher than the denominator for greater liquidity. The ratio indicates those assets which could be converted to cash very quickly for each short-term liability.

No.3) Debt equity ratio: This is the ratio of total debt to total equity; (Total debt / Total equity). Total debt includes both long-term and short-term. This ratio indicates how much solvent the company is – if debt is higher than equity such solvency is at risk.

No.4) Equity ratio: This is also a solvency ratio of total equity to total assets; (Total equity / Total assets). Since total assets are financed through either equity or debt, higher equity ratio is favourable because it indicates that assets are greatly financed through the company’s own capital and there is no interest burden on debt.