Balance Sheet Ratios Types

This article throws light upon the top six types of balance sheet ratios. The types are: 1. Current Ratio 2. Liquid Ratio 3. Absolute Liquidity Ratio 4. Proprietary Ratio 5. Assets to Proprietorship Ratio 6. Debt-Equity Ratio.

Type # 1. Current Ratio:

In the last decade of the 19th century, when the number of Financial Statements available to the creditors and to the public interested in activities of corporate enterprises increased, there arose among commercial banks and merchants interested in lending activities, the practice of comparing the amount of current assets of a commercial or industrial enterprise to the amount of its current liabilities.

This comparison gradually came to be known colloquially as the Current Ratio or 2: 1 Ratio. As the ratio has its link with the working capital it is also called Working Capital Ratio. It is obtained by dividing the Current assets by Current liabilities.

Current Ratio = Current Assets / Current Liabilities

A financial analyst takes this ratio into consideration for assessing the solvency and liquidity position of firms.

Creditors interest, particularly short-term, lie in this ratio since it indicates the extent of current assets available against each unit of current liability in a firm. The current assets are the sources from which the current liabilities namely, the immediate claims and obligations of a firm are met. It goes without saying that a firm will be able to meet its current liabilities provided its current assets are at least equal to the same.

The Normal Current Ratio is considered as 2 : 1 The reason in favour of prescribing ‘2 for 1’ current ratio is that all the current assets do not have the same liquidity, or in-short, all the current assets cannot be immediately converted into cash for a number of reasons.

For example. Debtors may not be realised in full, or some Debtors may take longer time to pay than they took earlier, Stock may not be sold for Cash as rapidly as was expected, credit sales may be higher than the cash sales etc.

Therefore, if the goodwill of the firm is to be maintained in respect of payment of liabilities, some provisions must have to be made as expectation does not always prove worth regarding the convertibility of current assets into cash and naturally a margin of safety is always required.

This margin depends entirely upon the circum­stances of the business, particularly, on sales position, that is, proportion of cash and credit sales.

If goods are always sold for cash, a small margin will suffice. But in case of credit sales, margin will have to be increased. Therefore, the amount of current assets must be higher than the amount of current liabilities.

Thus, the demand for a 100% margin of current assets over current liabilities is nothing but a precaution based on the practical experience of the possible shrinkages that may possibly occur in the property value of the business.

The other logic for prescribing 2: 1 current ratio can possibly be ascribed to the fact that a surplus of current assets will remain in the firm as working capital even if all current liabilities are liquidated by it at the close of its accounting cycle.

Window-Dressing:

It is a common knowledge that current ratio is used as a tool by the Creditors including Banks and other financial institutions in assessing the short-term solvency and liquidity position of a firm.

As current ratio is obtained by dividing the current assets by current liabilities, it needs hardly be stressed that correctness of current ratio, for the purpose it is worked out, will depend largely upon proper recording and valuation of both current assets and current liabilities.

If recording and/or valuation of current assets are manipulated along with a manipulation of the recording and/ or values of current liabilities with a view to show a better liquidity and solvency position of a firm, through a high current ratio, such manipulation goes by the name of Window-Dressing. A high current ratio, therefore, will be of no significance, if the same is the product of Window-Dressing.

A firm may resort to Window-Dressing in a number of ways, such as:

(i) Disposal of Trade Investments just on the eve of Balance Sheet date and the inclusion of the sale proceeds of the same in the Cash till or use the same to pay off current liabilities;

(ii) Carrying of inventories below the normal level by deferment of replenishment of stock before the close of financial year;

(iii) Inclusion of inventory, goods sold on credit, but laying undelivered to pur­chaser,

(iv) Deferment of replacement of fixed assets, such as Plant and Machinery, until after Balance Sheet date;

(v) Inclusion of good-in-transit into stock without simultaneous recording of credit for purchases.

Instances may be multiplied. All these maneuvers will bolster up the position of current assets, vis-a-vis, current liabilities giving a misleading current ratio which a business enterprise try to use to its advantages.

The following illustration will make the principle clear:

Illustration:

Now, let us suppose, the following techniques of Window Dressing are followed:

(a) The Investments are sold at cost and the proceeds are used to pay off the Creditors:

(b) The Fixed Assets to the extent of Rs. 10,000 are sold for Cash and the proceeds are not used to replace the same.

As a result of the above, the composition of current assets and current liabilities will be:

 

Hence, the Current Ratio is = Rs. 1, 10,000 / Rs. 40,000 = Rs. 2.75: 1.

It is, therefore, quite clear that this high current ratio is the product of Window Dressing.

So, Window-Dressing is something which a financial analyst has to guard against when he uses the tool of current ratio for fathoming the liquidity and solvency position of a firm, although in practice, it is very difficult for him to obtain the necessary information to detect it.

Weighted Current Ratio:

It has already been pointed out that all types of current assets are not equally liquid and all current liabilities are not repayable with the same degree of quickness.

Therefore, discrimination can be made among the different components of current assets and current liabilities, the former on the basis of the ease with which each individual current asset can be converted into cash without suffering any shrinkage in value, the later on the basis of relative quickness with which each individual item of current liabilities mature for payment.

This discrimination can be expressed by assigning proper weight against each component of current assets and current liabilities.

Weights to be assigned, on each individual compo­nents of current assets and current liabilities, will depend upon the degree of their relative liquidity in case of current assets and relative urgency of payments in case of current liabilities having due regard, however, in each case upon the nature and types of business.’ For instance, there can be no dispute that Cash and Bank are most liquid assets.

Accordingly, a weightage of 100% may be assigned to these items of current assets when current assets’ total of a firm comprises these two items. Receivables are no doubt liquid, but certainly these are not as liquid as Cash and Bank balances.

Accordingly, it is not possible to accord to this item of current assets a weightages of 100%. Weights to be assigned to this item of current assets have to be naturally less than 100%, say 80%.

In the same way, Inventory cannot rank at par with receivable in respect of liquidity. As such, lesser weight has to be assigned to Inventory. Again, when we speak of inventory, we bring within its fold at least three items viz. Finished Goods, Work-in-Progress and Raw Materials which differ inter se in respect of liquidity. Therefore, all these different components of inventories cannot be assigned the same weight.

As such, if a weightage of 70% is ascribed to Finished Goods, Work-in-Progress can have only say, 60% followed by Raw Materials to which a weightage of 55% may be ascribed. Thus, it is possible to ascribe different weights to different components of current assets.

Just as in the case of current assets, in case of current liabilities also, different weights can be assigned to different components of current liabilities on the basis of relative quickness with which each item of current liabilities mature for payment. For instance, a weightage of 100% can be assigned to pre-received income, receipts of advance from customers, proposed dividend and provision for taxation.

Accounts payable are no doubt current liabilities, but in view of prevalence of credit period, there is a time lag in case of accounts payable-for becoming due for payment.

Accordingly, if proposed dividend, amount received in advance from customers, provision for taxation etc., are given a weightage of 100%, accounts payable can only be assigned a weightage less than 100%, say 80%, followed by Bank Overdraft and others with weights lesser than 80%.

Once the weights have been determined for each individual component of current assets and current liabilities, these are to be multiplied by their respective weights in order to get the product. Thereafter, the total product of current assets and current liabilities are to be taken for dividing the former by the later.

The current ratio that is now obtained becomes the Weighted Current Ratio which is considered to be more representative and dependable than the Ordinary Current Ratio.

Needless to mention that, a Weighted Current Ratio will always be lesser than the Ordinary Current Ratio since it makes discrimination amongst the different components of current assets and current liabilities in respect of their respective liquidity and urgency of payments.

Illustration:

From the Balance Sheets presented by Z Co. Ltd., Calculate the Current Ratio (Ordinary) and Weighted Current Ratio (after assigning proper weights) for the year ended 31.12.1983 and 31.12.1984.

Solution:

It will be observed from the above that the Weighted Current Ratio of the company had been 1.77: 1 and 1.63: 1 in the year 1983 and 1984 respectively as against the Ordinary Current Ratio of 2: 1 and 1.87 : 1.

Time Dimension in Current Ratio:

The current assets and current liabilities, that we take into consideration, for the calculation of current ratio, are the aggregates of net balances available in the individual account representing the class on a specific date. Now, though the current assets and current liabilities are themselves Stock items, the accounts that the current assets and current liabilities comprise, are not themselves static. They are rather dynamic.

And this dynamism arises from the fact that with every transaction relating to them, there occurs a change in their respective balances. Consequently, identical balances do not occur in the current assets and current liabilities on the same days of a week, or month, or quarter, or half- year, or year of the two periods.

If the balances in the current assets and current liabilities change, there cannot but be a change in the current ratio as well.

It should, however, be noted that variation in the daily, monthly, quarterly, half- yearly and yearly position of current ratio of a firm cannot be studied by the financial analyst of all categories. It is only an internal financial analyst who can do this. For, an internal financial analyst has free access to daily, monthly, quarterly, half-yearly and yearly data pertaining to current assets and current liabilities.

As such, it is not difficult for him to ascertain the current ratio and notice the variation thereof, in the aforesaid periods. But the same is not true in respect of an external financial analyst. He has no free access to daily, monthly, quarterly, and half-yearly data pertaining to current assets and current liabilities.

As a result, it becomes difficult for him to ascertain the current ratio and its variation in the periods mentioned. He can only study the yearly position of current ratio from the published annual reports of a firm and note the variation thereof in different years.

Secondly, the oblique position of external financial analyst vis-a-vis, data relating to current assets and current liabilities, creates another problem. In the assessment of imme­diate solvency position of a company, an external financial analyst has to base his calculation on data of current assets and current liabilities that obtained in the company on a specific date of the past period, normally, the yearly closing date.

But in view of the dynamism in the accounts that represent the current assets and current liabilities, there is no guarantee that the same amount of current assets and current liabilities will be obtained in the company on the day, the external financial analyst goes to make an appraisal of the said solvency position in the perspective of current ratio on the last Balance Sheet date.

Current assets and current liabilities of the firm may be more or may be less than that prevailed on the date, the Balance Sheet was drawn up. Consequently, current ratio also will be different. This shows that current ratio has a time dimension.

Time Adjusted Current Ratio:

When we calculate the current ratio by dividing the current assets by current liabilities, we ignore the basic reality that all the components of current assets may not be good or worth their book values. And secondly, different components of current assets have not the same degree of liquidity.

Liquid ratio, no doubt, is an improved version of current ratio, but the same is not also absolutely free from snags. For instance, liquid ratio provides an unequal comparison between current assets and current liabilities, since, current assets in the ratio are taken only in segments, but current liabilities in their total. Besides, it treats receivables and Cash and Bank balances at par.

The above problems could have been avoided if all current assets would have the same degree of liquidity and could be realised at their book values. But even then, a problem would remain and it would arise from the fact that the sum of money received in future is less valuable than it is to-day. In other words, the problems appear from what is known as time value of money.

If current ratio is to be used as an index of liquidity, the challenge that it confronts from Time value of money also needs tackling. And the best way to meet the challenge appears to be the computation of Time Adjusted Current Ratio by the application of the following formula for adjusting values of current assets and current liabilities in recognition of Time value of money.

Where,

D = Discount factor;

i = Annual earning rate and is taken as the discount rate;

n = The total cycle time taken to convert Cash into Finished Products, Finished Products into Debtors and ultimately back to Cash.

Usually, in DCF (Discounted Cash Flow) calculation, the discount rate is based on the cost of capital. But, here it is different. The rate should be the company’s earning rate before tax. This naturally would be much higher than the cost of capital which is used to find out the Net Cash Flow after tax in DCF computations.

If the cost of capital is 16%, with 60% taxation, the discount rate, in our calculation, would be say 45%. This is also the discount rate that has been followed in the illustration given below to demonstrate how we can ascertain Time Adjusted Current Ratio to meet the challenge offered by the Time value of money.

Illustration:

From the following Balance Sheets presented by X. Co. Ltd. for the year ended 31.12.1983 and 31.12.1984, Calculate the Current Ratio and the Time Adjusted Current Ratio.

Solution:

In the Calculation of Time Adjusted Current Ratio’ the following technique has been followed:

(a) The time span in respect of conversion of each current asset into Cash and payment of each current liability in Cash has been estimated in terms of number of weeks requirement. This has been shown in Column 2.

(b) In respect of each current asset, number of weeks (cumulative) in terms of operating cycle has been calculated and shown in Column-3. In respect of current liabilities, however, only number of weeks has been taken into consideration.

(c) Discount factor in respect of each current asset and current liability has been ascertained by the application of formula stated earlier and the same has been shown in Column-4.

(d) Time adjusted values of each current asset and current liability has been ascertained by the multiplication of discount factor in respect of each of them shown in Column-5.

Type # 2. Liquid Ratio:

It is the ratio between quick or liquid assets and quick liabilities. It is also called ‘Acid Test Ratio’ Quick Ratio’, or Wear Money Ratio’.

The normal for such ratio is taken to be 1: 1. As a tool for assessment of liquidity position of firms, it is considered to be much better and reliable than that of the current ratio as it eliminates the snags in the same, since it indicates the relationship between strictly liquid assets whose realisable value is almost certain on the one hand, and strictly liquid liabilities on the other.

Liquid assets comprise all current assets minus Stock.

Similarly, prepaid expenses are also excluded from liquid assets as they usually are not be converted into cash and liquid liabilities comprise all current liabilities minus Bank Overdraft. Stock is excluded from liquid assets on the ground that it is not converted into Cash in the immediate future and at the same time Bank Overdraft is excluded on the ground that it is not required to be paid off in the immediate future.

Practically, it is the true test of solvency of the business. It indicates the ability of the business to pay its maturing obligations without delay and difficulty.

Type # 3. Absolute Liquidity Ratio:

Liquid ratio measures the relationship between Cash and near Cash items on the one hand, and immediately maturing obligations on the other. But as the com­position of Cash and near Cash items, in the calculation of liquid ratio, comprises accounts receivable also, doubts have been expressed about the efficacy even of this ratio as a flawless tool for measuring liquidity position of a firm.

It is argued, that, accounts receivable included in the denominator of liquid ratio, may suffer in realisable value, because of the possibility of bad debts, though compared to inventories, accounts receivable are more liquid as an item of current assets.

Therefore, a real measure of liquidity will be the ratio between cash and marketable securities to immediate maturing obligations which is termed as Absolute Liquidity Ratio. The normal for such ratio is taken to be 1: 1.

Type # 4. Proprietary Ratio:

It is the ratio of Proprietor’s Fund to Total Assets.

Proprietor’s Fund/Net Worth =

Equity and Preference Share Capital + Reserves and Surplus – Accumulated Fund – Debit balance of P & L A/c and Misc. Expen­ditures.

It reveals the owners’ contribution to the total value of assets. There is no hard and fast norm in this regard. Yet 60% to 75% of the total assets should be financed by the proprietors’ fund. The higher the ratio the lesser will be the reliance on outsiders, although too high a ratio may not be good for it. It would imply that external equities were not utilised properly.

Type # 5. Assets to Proprietorship Ratio:

(i) Total fixed Assets to Proprietors’ Equity:

It reveals how much of proprietors’ fund is being invested in fixed assets. If the major part is invested in fixed assets working capital may be inadequate.

Normally, 60% to 75% should be invested in fixed assets.

Total Fixed Assets to Proprietors’ Equity Ratio = Total Fixed Assets / Proprietors’ Equity

(ii) Total Current Assets to Proprietors’ Equity:

It indicates how much of proprietors’ fund is being invested in current assets. If the investment is found to be too small, working capital may be inadequate.

Total Current Assets to Proprietors’ Equity Ratio = Total Current Assets/ Proprietors’ Equity

Type # 6. Debt-Equity Ratio:

It expresses the relation between the external equities and internal equities or, the relationship between borrowed capital and owners’ capital. It is a measure of long-term solvency. It reveals the claims of creditors and shareholders against the assets of the firm, i.e., comparative proportion of Debts and Equity.

Here, Debts and Creditors include, all debts whether long-term or short-term, or in the form of Mortgage, Bills and Debentures etc. On the other hand, owners’ claims consist of Equity and Preference Share Capital + Reserves and Surplus + Capital Reserves etc. The norm of such ratio is 2: 1.

The higher the ratio the greater will be the risk to the creditors and this indicates too much dependence on long-term debts. On the contrary, a lower ratio reveals a high margin of safety to the creditors.

Capital Gearing Ratio:

It is the ratio between Equity Share Capital and Fixed Interest-bearing securities. It defines the relative proportion of Equity Share Capital and Fixed Income-bearing Securities to total capital employed in the business.

The business is said to be highly geared if the Preference Share Capital + Debentures are proportion­ately higher than the Equity Capital. In the opposite case, it is low-geared. The norm of such ratio may be taken as 2: I.

Assets Cover:

(i) Ratio of Assets Cover of Debentures.

(ii) Ratio of Assets Cover of Ordinary Creditors.

(iii) Ratio of Assets Cover of Preference Shareholders.

(iv) Ratio of Assets Cover of Equity Share Capital.

(v) Security Cover.

Assets cover reveals how much of the assets are covered by the respective claimants. As for example, Assets cover of Preference Shareholders means: assets (less securities for Secured Creditors, if any) available for Preference Shareholders by the number of Preference shares which ultimately indicates the assets available for each rupee of Preference share.

Same principle is being applied in other cases also. But security cover means value of securities covered for secured loans.

Illustration:

From the following particulars presented by P. Co. Ltd., compute the following Balance Sheet Ratios, viz.,

(a) Current Ratio;

(b) Liquid Ratio;

(c) Absolute Liquidity Ratio;

(d) Proprietary Ratio;

(e) Assets- proprietorship Ratio:

(i) Fixed Assets to Proprietors’ Equity,

(ii) Current Assets to Proprietors Equity;

(f) Debt-Equity Ratio;

(g) Stock to Current Assets Ratio;

(h) Stock to Working Capital Ratio;

(i) Current Assets to Working Capital Ratio;

(j) Current Assets to Liquid Assets Ratio;

(k) All Long-term Funds to Working Capital Ratio;

(I) Tangible Assets to Working Capital Ratio;

(m) Tangible Assets to Current Liabilities Ratio;

(n) Capital Gearing Ratio or Gear Ratio

Solution: