Common ratios to assess the financial stability of a business concern gearing ratio, current ratio and liquid ratio. Gearing ratio indicates the degree of dependence of a company on debt to finance its activities. If the proportion of the debt climbs (especially when 65 per cent of total resources for most companies exceeded), the greater the risk of financial distress. This is the downside of financial leverage -. It increases the financial risks
Current ratio measures the number of times to cover the current assets of a company’s current liabilities. This is a measure of solvency: the ability of a company to pay its debts in the normal cash cycle, selling the inventory on credit, collecting debts and paying creditors. This ratio should normally be no more than 1: 1 and must be closer to 2: 1 should also be noted that an excess of assets will result in poor asset utilization.
Liquid or quick ratio is a stricter measure of short-term financial stability. It measures the firm’s ability to pay its current liabilities from its cash resources. Liquid assets are cash or near cash. In practice, liquid assets include cash, bank, short-term securities and receivables, assets that are easily converted into cash to meet immediate calls for payment from lenders and suppliers.
Accounts receivable are normally included in liquid assets because they can be sold to a finance company at a discount for later collection of accounts receivable. This is called debt factoring. Debt factoring is not common in other countries. Debt factoring is used as a means of managing the cash flow from operations, instead of trying funds entity debtors. Upon reaching the cash, the principle exclusion of current assets inventory. and then often to credit customers – – because it can take several months to sell it may be many months before money is collected from the inventory. Under current liabilities, some debts are not owed can be for many months. These can be excluded in the calculation of the fluid ratio. Examples include tax payable and current portion of long-term debt, both of which can take several months. However, such adjustments should be made only if the repayment dates are known and are more than six months later than the closing date.
A common (but risky) adjustment of the calculation of the liquid ratio is overdraft of the closing liabilities. When a liquid ratio tends to (or below) the 1: 1 level (including overdraft), this is probably time that the bank requires repayment – on demand. Therefore, an overdraft has to be omitted solely from this calculation when the company is perfect liquid – When it does not matter
Since these ratios are based on the statement of financial position, they represent only a snapshot ” the financial stability of the company, which at one point in time. These ratios can be manipulated by referring payments or purchases to postpone until the next period, either by billing customers before delivery. known as ‘window dressing’ , such techniques have improved solvency balance sheet date.