Coming Soon The Complete Book of Financial Ratios - By CA. Swati Sinha

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Eurion Constellation

The encyclopedia of financial ratios! An ideal companion for professionals, students, and everyone else:

A collection of over 45 ratios covered in depth Niche metrics, such as cash position ratio, absolute liquid ratio, proprietary ratio, etc Formulas, choice of parameters (along with the rationale for including or excluding certain items), and interpretation Other relevant aspects related to ratios are discussed separately Lucid presentation - for easy comprehension Detailed - for professionals and experienced readers Focus on understanding of concepts, rather than rote-learning Key definitions and glossary of terms A quick recap of all the ratios

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Liquidity Ratios: The Case For/Against Bank Overdrafts Liquidity ratios are used to measure an entity’s ability to fulfill its financial obligations in the short-term, i.e. they are measures of a firm’s liquidity. In layman terms, this translates into ready cash or instruments that can realize cash readily. Short-term here refers to a period of 12 months or less. Two of the most important liquidity ratios are the Current Ratio and the Quick Ratio. The formula for Current Ratio, or Working Capital Ratio, is: Current Ratio = Current Assets/Current Liabilities

The Quick Ratio, or Acid-Test Ratio, is represented as: Quick Ratio = [Current Assets – Inventories – Prepaid Expenses]/[Current Liabilities – Overdraft]

Fundamentally, these ratios relate to the assets and liabilities that come up in the course of the day-to-day activities. By definition, quick ratio takes into account the most readily realizable assets, and temporary liabilities with short maturity periods. The opinions, on whether or not the bank overdrafts should be included in the calculations of the liquidity ratios, remain divided. An overdraft is usually a short-term arrangement of loans to cover any temporary shortfalls in the cash resources. The interest is chargeable only on the amounts drawn against the allowed limit. Such interest often accrues at very short intervals and is usually variable. As the borrowing firm has to allocate its resources for regular monitoring of the interest rate, and renegotiating of the borrowing terms, overdrafts are sparingly drawn, only when required. In addition, the overdraft facility can be cancelled at any time. These factors bring out the essential short-term nature of this mode of financing. Therefore, most analysts prefer to include it as a part of current liabilities and that of the Current Ratio. Nevertheless, some take a different view. Bank overdrafts are drawn against credit lines that usually extend for periods beyond a year and are often renewed on expiry. In addition, most of the organizations keep such facilities to be used when needed. More or less, these instruments become a permanent source of financing. As a common practice, bank overdrafts are not callable on demand, adding a further degree of permanence. This explains why, as a convention, they are excluded from the calculation of the Quick Ratio. The final decision, to include or exclude, will depend upon the specifics of the case at hand, for instance, if a credit facility is due to mature in the short-term with no intention of the organization to renew it, it may be prudent to include the overdraft in calculations. Similarly, if an overdraft is callable on demand, it is definitely a part of the Current Ratio, and subject to other details, it may well form a part of the Quick Ratio.

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How to Calculate Quick Ratio Quick Ratio, by definition, is a more stringent measure of liquidity as it omits outs any element out of the current assets with the slightest of illiquidity. Similarly, those liabilities that may not be due in the near or immediate term are left out. Steps in Calculation: 1. Consider the total current assets on the balance sheet. Depending upon the discloser on the face of the accounts, you might have to look into the notes for breakup of the current assets. 2. Restricted Cash. Out of the total current assets, deduct ‘restricted cash.’ Such cash is not available for immediate use due to certain statutory or other encumbrance. 3. Inventories. Deduct ‘inventories.’ The accumulated saleable goods can be liquefied only upon a sale. Therefore, they may not be readily realizable as and when needed. 4. Prepaid Expenses. Further subtract prepaid expenses from above. Though prepaid expenses are assets in that they imply some definite future outflows already met, they cannot be converted into cash, if required. It is extremely rare that advance payment for business expenses are refunded by the third parties. 5. You arrive at the ‘quick assets’ that typically include cash, cash equivalents (marketable securities), and accounts receivable/debtors. 6. Consider total current liabilities and its breakup. 7. Bank Overdraft. Subtract bank overdraft from the total current liabilities. Bank overdrafts are drawn against credit lines that usually extend for periods beyond a year and are often renewed on expiry. More or less, these instruments become a permanent source of financing. As a common practice, bank overdrafts are not callable on demand, adding a further degree of permanence. 8. You get quick liabilities that typically include accounts receivable/creditors, current portion of long-term debt, income tax payable, and accrued expenses of various types. 9. Use formula for final calculation to arrive at the ratio: Quick Ratio = Quick Assets/Quick Liabilities

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