Question

Please select and define two ratios that measure liquidity and solvency. Please also include the formula for those ratios.

Answer 1

Solvency ratio and Liquidity Ratio both are helpful for analyzing the financial health of the organisation.

Solvency ratios are important for the analysis of the capacity to meet the long term financial commitments of the organisation.

Liquidity Ratios are important for analysis of the ability to pay short term obligations.

SOLVENCY RATIO:

Debt To Equity Ratio: Long Term Obligations / Shareholders Fund

Long term obligations includes long term loans, Debentures, Bonds, and other such long term obligations.

Shareholder's Fund includes Equity Share Capital, Preference share capital, Reserves and Surplus. Fictitious assets shall be deducted.

It measures the relation between the Long term obligations and the shareholder's fund available.

It shows the leverage. Lower Ratio indicates more security, while high ratio indicates more risk. If the ratio is low, equity is more invested than the debt, in case high ratio, the debt is on higher side.

There is no standard for all industry. But it can be kept as 2:1. which means Twice amount of debt to Equity.

LIQUIDITY RATIO

Current Asset Ratio:

Current Assets/Current liability

Current Assets includes inventory, Trade Receivables, Cash and Bank Balances, Short term notes receivables. Advances, Prepaid Expenses and all other short term assets and marketable securities.

Current Liability Includes Trade Payable, Bank Overdraft, Liability for unpaid outstanding expenses, short term notes payable.

The standard for this ratio is 2:1.

this ratio measures the ability to pay the short term liability from the current assets of the organisation.