Question

COMPUTE AND ANALYZE THE LIQUIDITY RATIOS: CURRENT RATIO, ACCOUNTS RECEIVABLE TURNOVER, INVENTORY TURNOVER. EXPLAIN HOW THEY AFFECT INVERSTORS' OR CREDITORS' DECISIONS REGARDING THE COMPANY.

Answer 1

Liquidity Ratios are the financial indicators that whether the company's current assets and suffiicient enough to meet the company's current debt obligations.

Current Ratio:It measures financial strength of the company

Formula :Current Assets/Current Liabilities

Current Assets: Cash in hand,cash at bank,stock,short term investments,advances,Debtor

Current liabilities: Amounts payable,creditor,shorts term loans,bank overdraft.

It compares firm's current assets to current liabilities.Generally 2:1 is treated as ideal current ratio.

Increase in the numerator (current assets) increases the ratio while increase in denominator(current liabilities) decreases the ratio.

Investors look at current ratio before sanctioning any loan for the company checking its financial health and creditor look at current ratio to check whether the company will be able to pay off its credit outstanding (dues) timely or not.

Accounts Receivable Turnover Ratio :An activity ratio which mesaures how efficiently firm can use its assets.

Formula: Net Credit Sales/Average Accounts Receivable

It is also called as debtors turnover ratio and it is usually calculated annually or may be quaterly.

It basically shows the firm's efficiency to collect the dues from customers.The ratio between the net credit sales and collection from customers/debtors.On one hand it shows that company is well efficient or the customers are quality ones that it is able to collect cash out from credit sales quciky but on other hand it can give image that company is following a very tight credit policy which can drive away good customers.

Sooner the customers pays off to company the sooner company will have cash or bank funds in their account to pay of interest or debts to the investors and creditors ,hence it is of importance for them to check the accounts receivable ratio before start dealing with the company.

Inventory Turnover Ratio:It is an efficiency ratio which shows how efficient the company is in generating sales from its inventory.How effective it is in managing its stock and how well it is clearing off its stock and converting them into sales so as to avoid the stock storage cost.

Formula: Cost of Goods Sold or Sales/Average Inventory

Average Inventory=(Opening inventory +closing inventory)/2

It helps the outside parties like creditors or invetsors that how fast and efficiently the company is managing its inventory and also the cost associated.Too much inventory tied up not only indicates burden on working capital and financial trouble but also indicates that the company is a less effiecient competitor.Creditors will plan their credit terms and sale of stocks to company accordingly because they will be looking for faster sales and faster payments of outstanding dues.