Financial ratios are the nuts and bolts of financial statements. They could be a very handy tool for investors. But they are useful only if you know which nut and bolt fits where. Otherwise, handling so many financial ratios could be painful. A few
weeks ago, our friends Jinny and Johnny talked about one of the most important ratios — the P-E multiples. Now Johnny wants to understand some more ratios: liquidity ratios, turnover ratios, coverage ratios, profitability ratios or any other ratio he can lay his hands on.
Illustration: Jayachandran / Mint.
Jinny: Hi, Johnny! You are looking quiet today. What’s the matter?
Johnny: I have been looking at financial statements of a few companies but I don’t really know how I can compare their strengths and weaknesses.
Jinny: Well, financial statements of companies are full of numbers that can tell you a lot about companies’ strengths and weaknesses but the problem is that numbers talk with numbers only. So you can make an intelligent analysis only if you know how to establish the relationship between different set of numbers.
In this respect, financial ratios are of great help. They provide us relationships between two different sets of numbers. In a nutshell, they can tell us how effectively the company is managing its inventory or how quickly the company is receiving its sales proceeds. To find the right answers, we just need to choose the right ratio.
By comparing financial ratios we can very well compare the performance of two different companies or the present performance of the same company with its past performance or with the present performance of the industry as a whole.
Johnny: It seems ratios are of great use. Tell me about some key financial ratios.
Jinny: There are a lot many ratios, each having its own significance. Today I will tell you about just one of them, so let’s start with the liquidity ratios, the favourite of lenders of companies. Liquidity ratios tell us how well placed a company is in meeting its short-term liabilities. The most basic liquidity ratio is the current ratio, which can be obtained by dividing the current assets by current liabilities. This ratio tells us how many times the current assets are worth in terms of the current liabilities. If the current ratio is 2, then it means that the current assets are worth two times the current liabilities. That means the company is in a position to comfortably pay its dues.
But, you may ask, what exactly is included in the current assets and liabilities? Well, current assets are assets which can be converted into cash within a short period of time, normally not exceeding one year. It includes many things, such as cash and bank balances, investments in different securities, money receivables, short-term loans and advances, inventory of raw materials as well as stock in progress and finished goods, etc.
Current liabilities are short-term obligations which the company has to meet within the next one year. It includes all short-term borrowings repayable within one year, instalments and interests of term loans, deposits maturing within one year, sundry creditors for raw materials, stores and consumable spares, etc. You can find the current assets and liabilities of the company from its balance sheet.
Johnny: What other liquidity ratios can be used?
Jinny: Well, we can also use the acid test or quick ratio to make a more strict measurement of liquidity. This ratio excludes inventory from the current assets of the companies. This means that only cash and bank balances, investment in different securities and money receivables are treated as current assets. Current liabilities include all the components that I have told you about.
Why are inventories excluded? This is done because it is difficult to convert inventories like raw materials or stocks in progress quickly into cash. Even finished goods can be converted into cash only with some time lag. The quick ratio tells us how well placed the company is in quickly meeting its short-term obligations. A company that has a high quick ratio is keeping its chequebook ready and will not ask its lenders to pick up unsold fish curry as repayment of its debt. Good for lenders.
But there is yet another ratio, called super acid test or super quick ratio, that measures liquidity in even more strict terms. This ratio treats only cash, bank deposits and investments in different securities as current assets and excludes money receivables from current assets. Money receivables are what others owe us and sometimes it is really difficult to get them back.
A company with a high super quick ratio is keeping most of the money in its own pocket. A good sign if the company owes you money, but not a very good sign for the owners of the company. A high super quick ratio means that the company is keeping its cash idle. That’s not a very smart way of doing business.
Johnny: That’s true, Jinny. Sitting on idle cash is like sitting on fire.
What:Financial ratios help in analysing the financial statements of companies.
Who: Lenders and investors examine liquidity ratios to understand how well a company is placed to meet its short-term liabilities.
How: Different liquidity ratios compare different elements of current assets with current liabilities.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org