Question

What two companies that uses ratios to explain liquidity, solvency, and profitability, and its effect on a business?

Answer 1

Ratio Used by companies to explain-

Liquidity Ratio-

a] Current Ratio: This ratio defines the level of current asset against the current liabilities of company at particular time.This ratio allows company to evaluate it's liquidity in case of emerency. This ratio explains, whether company's current assset is enough to meet the current liabilities in case of any sudden need of payment to current liabilities.

Formula: Current Asset/Current liabilities

b] Quick Ratio: Quick ratio is also pronounciated as acid test ratio, which discuss company's ability to meet current liabilities in very short period. While calculating this ratio only more liquid assets are taken prepaid expenses and inventory in warehouse are left in calculating the quick asset. This gives a clear picture to the investor's about absolute cash situation of company's quick asset vs company's current liabilities. This ratio has an assumption that company may not be able to realise inventory and prepaid expenses in very short period of time hence, it should be excluded from calculation of company's current asset which may be realised at any time of urgency.

Formula: Quick Asset/Current Liabilities

Solvency Ratio-

Debt Ratio: This ratio allows investor's and companies to evaluate that how much of total asset of company has been obtained from finance i.e from incurring liabilities.This Ratio specifies whether company's asset is not extremely financed with debt only. This may create unwanted fixed interest burden on company in long term and thereby pulling the company into danger of solvency. In long term if the investment in those asset do not pays expected cash outflows then there may be problems of solvency and cash crunch. This suggest that more focus should be paid on acquiring assets from own cash and not with debts.

Formula: Total Liabilities/ Total Asset

Debt to equity Ratio: This Ratio explains the level of debt against the level of equity, a company posses at a particular time. This ratio suggest that a balance should be maintained between the company's debt and equity. The company should not be over burdened by the debt only and similarly company should not be receiveing more cash towards equity. Excess of debt may result into high fixed finance cost, while excess of equity finance may not allow a company to take tax benefits which are given in payment of fixed interest costs only. Since payment made to equity holders is taxable as Dividend distribution tax.

Formula: Total Debt/Total Equity

Profitability Ratio's-

Gross profit Ratio: This ratio suggest tha company is earning a level of gross profit against level of company's sale during a particular period.This ratio explains the gross profit against company's sale.Higher the gross profit, higher the net profit.Gross profit is Sales minus cost of goods sold, which does not take into consideration of indirect expenses incurred in production process.

Formula: Gross profit/ Net sales

Net profit ratio: Net profit ratio is ratio which determines company's net profitability against the company's sale.This evaluates company's abiltity to genrate the net profit at a level of sale.This ratio also evaluates Effectiveness of comapany's operation in competitive market.In the time of cut throat competition, If company generates profit then it is a positive covenent.How much net profit should be, is based on industry and peers.

Formual- Net profit/Net Sales.

Please comment for any additional explanation.

Thanks.