Question

Give examples and explain one ratio for each of the following ratio classification groups. (10)
 Liquidity ratios
 Profitability ratios
 Activity ratios

Answer 1

Liquidity Ratios are those ratios which are ment to test the firms ability to pay for the short term obligations. Examples include, current ratio, Acid test ratio ( liquid ratio) and absolute liquidity ratio.

Current ratio = Current assets / Current liabilities.

As seen from the above formula, current ratio establishes a relationship between assets that convert into cash in short term and payments that had to made in cash with that short term. Thus if the ratio is more than ONE, it indicates that firm will be able to pay for its short term obligations. Normally a ratio around 2 times is generally considered as preferable or true test of liquidity using current ratio.

Profitability ratios are used to test the adequacy of profits earned by the business. It includes various ratios like, Gross margin ratio, Net margin ratio, ROI ( Return on Investments)

Gross margin ratio = Gross Margin / Sales * 100

Above ratio explains the gross margin in percentage terms. When compared with benchmards of various firms in the industry, the company know about its relative position in each of the profiability ratios and take active measures to improve upon them.

Activity ratios : These ratios are otherwise known as turnover ratios. Number of times turnover is generated with the use of various resources is calculated. They include, Assets turnover ratio, Working capital turnover ratio, Inventory turn over ratio etc.

Assets turnover ratio = Sales / Total assets

Working capital turnover ratio = Sales / Working capital