Question

QUESTION 4:

Explain the importance and limitations of current ratio in measuring company’s liquidity (make sure you refer to the effect of each component included in calculating current ratio).

QUESTION 5:

Can a company reply on net income as a valid measure of cash needed to pay fixed charges? Explain you answer

QUESTION 6:

Explain why companies do not include principle payment requirement when calculating earnings to fixed charges ratio.

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QUESTION 4:

Explain the importance and limitations of current ratio in measuring company’s liquidity (make sure you refer to the effect of each component included in calculating current ratio).

QUESTION 5:

Can a company reply on net income as a valid measure of cash needed to pay fixed charges? Explain you answer

QUESTION 6:

Explain why companies do not include principle payment requirement when calculating earnings to fixed charges ratio.

Answer 1

4.Importance and limitations of current ratio in measuring company’s liquidity

Current ratio is an indicator of short-term financial health of a company--ie. The capacity of te company to repay its less-than-a year obligations, at shortest possible time--which , in other words, is called liquidity

It is more about the convertibility of their current assets to cash , in case of need --meaning any trade creditor pressing for money or any bank overdraft need inventory /receivbale to pledge, etc.

The formula to calculate current ratio is Current assets/Current liabilities

Current assets include cah & cash equivalents , accounts receivable, inventory , prepaid expenses --all necessary for regular operations and some short-term investments.

Current Liabilities include trade payables & all other less-than-a year obligations, arising out of operations.

So,the most of both the current assets and the current liabilities , are required for and also consequent to, the regular operations. Hence their net , (ie. Current assets-Current liabilities) is termed as working capital .

Acid-test ratio or quick ratio is a variation of current ratio--in that it leaves out inventory & prepaid assets from the current assets and calculate the ratio with the balance -to know the very immediate liquidity of the remaining current assets .

Normally manufacturing companies maintain current assets to the tune of 2 times the current liabilities & quick assets equal to the current liabilities -- even though both differ from industry to industry.

Importance

1.Current ratio is the single most important metric to gauge the liquidity position of any business.

2.Looking at the number,ie. Less than /more than / equal to 2 , the manager can assess the situation & take action accordingly.

ie. If it is less than 2,he decides to keep a close watch, if any liabilities arise & contemplate ways to meet them.

If it is more than 2, he needs to divert the more-than -necessary funds to some income-earning opportunities , so as to generate more working capital--- so that the company need not have unproductive/idle funds.

3.Comparing the ratio with that of peers in the industry, or the industry average, or with his own previous years' figures, the manager can assess & correct, if necessary, his working capital position , to be on par with the industry.

4. In short, this ratio is the mirror that reflects the working capital/operational efficiency of a business concern---the very purpose for which the business had been formed.

Limitations

1. The main limitation of any ratio is the correctness of all the numbers that add to it, ie. Accuracy of Individual components like accoounts receivable, payable, inventory, etc.---any over/under statement of those numbers is bound to affect the ratio also.

2.There may be obsolete or non-moving stock in the inventory, which may give a pepped-up & misleading curent ratio number --so care should be taken to remove such items , which have least liquidity.

3. Similarly, with receivables--- for seasonal businesses that have high sales at peak seasons & very low sales at of-seasons-- there is no use comparing the current ratio at all times---as it is bound to have more receivables at paek times & the current ratio will be on/above par , depending on sales performance & very low at other times---- so care shuold be given to all these facts.

That said, current ratio is the best available tool to assess short-term financial health of a business, only, if used in an appropriate manner, so as to generate meaningful information.

5. Can a company reply on net income as a valid measure of cash needed to pay fixed charges?

NO.

Net income includes , a good number of non-cash items of expenses/incomes

ie. It is after accounting for expenses and incomes that have been accrued , in accordance with the matching principle of accounting,

ie.Recording expenses in the relevant period , in which the revenues were earned .

for example, salaries & wages of employees pertaining to the current period , not yet paid , by the end of the period

rates & taxes pertaining to the period, which fall due after the end of the period

gain/loss on disposal of assets

bad debts provision

depreciation provisions

So, we need to remove all non -cash charges & credits to net income & then arrive at cash income & then compare the fixed charges to be paid.

6.Why companies do not include principle payment requirement when calculating earnings to fixed charges ratio.

Because principal repayment is repayment of the cash already received into the business , in the form of financing cash inflows. At that time,earnings were not credited with that amount.

Also, fixed charges for the usage of the above funds, like interest & lease charges are expenses & hence met out of the earnings generated , by using those funds for acquiring assets /expansion , etc.these are charge against profits --as they are revenue in nature.

whereas, principal repayment , is capital in nature & will not affect the regular operational results, even though they aid in generating revenues.