Question

(a) Funders use some financial analysis ratios for determining the financial health of a business’ ability to meet its financial obligations; both short-term and long term. What are these indicators for short-term financial health called, and how are they defined ?

(b) What is this indicator for long term financial health called and how is this defined?

Answer 1

(a) Below are the indicators for short-term financial health:

Liquidity ratios

• Current Ratio = Current Assets / Current Liabilities

This signifies the constituents of working capital depicting the safety marging by way of excess of current or short term assets over current or short term liabilities (short term is generally =< 1 year). It should neither be too high nor too low. Generally 2:1 is acceptable as common benchmark.

• Liquid Ratio or Quick Ratio or Acid Test Ratio = Liquid Assets / Current Liabilities

Liquid assets means cash and cash equivalents like bank balances, bank deposits, etc. which are readily convertible into cash without much deterioration in value.Generally 1:1 is acceptable as common benchmark.

(b) Below are the indicators for long term financial health:

Solvency Ratios

• Debt Equity Ratio = Long term external liabilities / Shareholders'funds

A low debt equity ratio reflects more ssecurity to lenders and vice versa.The general benchmark is 2:1

• Debt Service Coverage Ratio = PBIT / Interest obligation on long term Debt

It reveals the number of times interest on long term debts is covered by Profit before Interest & Tax. A higher ratio ensures safety of interest on debts.