Q. 2. Explain balance sheet ratios with examples

Answer

The following are the important balance sheet ratios:

Current Ratio

Current ratio can be calculated as:

Current ratio = Current assets / Current liabilities

Current assets are: cash in hand, cash at bank, bills receivable, sundry debtors, inventories, work in progress and prepaid expenses.

Current liabilities are: Bills payable, sundry creditors, sundry outstanding expenses.

Quick or Acid test Ratio or Liquid Ratio

The term liquidity refers to the ability to pay its short term liabilities as and when due for payment here out of Current Assets inventories and prepaid expenses are not included as these cannot be converted into cash
easily. Thus,

Quick ratio = (Current assets – Stocks prepaid) / Current liabilities

Example 1

Calculate Quick Acid test Ratio from the following Balance Sheet:

$$
Bank Loan2,00,000Land and Building5,90,000
Creditors3,00,000Stock in trade2,70,000
Bills payable40,000Debtors1,40,000
Outstanding Exp.20,000Cash in hand / Bank2,50,000
8% debentures4,00,000Marketable securities3,00,000
Plant / Mach. funds6,00,000Prepaid expense (Ins)10,000
15,60,00015,60,000

Quick Ratio = Quick Assets / Current Liabilities

Quick asset = $1,40,000 + 2,50,000 + 3,00,000 = $6,90,000

Current liabilities = $3,00,000 + 40,000 + 20,000 = 3,60,000

Quick Ratio = 6,90,000 / 3,60,000 = 1.916 times

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Hint: Bank loan is long term liability of course Bank overdraft is considered as current liability

Quick Assets: Don’t include stock and prepaid expenses.

Example 2

Calculate current assets and current liabilities when current ratio is 2.5, working capital is $1,80,000.

Solution

Working Capital = Current Assets – Current Liabilities

Current Ratio = C.A : C.L

= 2.5:1

Thus,

1,80,000 / 1.5 = 1,20,000

C.A = $1,20,000 x 2.5 = $30,000

C.L = 1,20,000 x 1 = $1,20,000

Example 3

Calculate current assets liquid assets and inventory from the following:

Current ratio: 2.5:1
Acid test ratio: 1.5:1
Current liabilities: $50,000

Solution

Current Ratio = Current Assets / Current Liabilities

2.5 = Current Assets / 50,000

Current Assets = 2.5 x 50,000

C.A. = $1,25,000

Acid Test Ratio = Liquid Assets / Current Liabilities

1.5 = Liquid Assets / 50,000

Liquid Assets. = 1.5 x 50,000 = $75,000

Inventory = C.A. – Liquid Assets

= $1,25,000 – 75,000 = $50,000

Debt Equity Ratio

This ratio is a claim of creditors on Assets of the organisation. It is calculated by dividing total assets (C. A. and Long term assets) by tangible network. When this ratio is greater, it means that creditors have invested more in business than the owners, and the creditors will suffer more in adverse times than the owners. Therefore, it is advisable that creditors prefer low equity ratio.

Debt Equity Ratio = Outsiders fund / Shareholder’s fund

or

Debt Equity Ratio = External equities / Internal equities

Proprietary Ratio or Equity Ratio

This ratio establishes relationship between shareholder’s funds to total assets of the firm. This ratio is useful for long term solvency of the firm. The shareholder’s fund includes equity, preference share capital. ,
Profits and loss, reserves and surplus.

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Equity Ratio = Shareholder’s fund / Total assets

Example

Shareholder’s fund is $4,00,000, total assets are $6,00,000. Calculate the equity ratio.

Equity ratio = 4,00,000 / 6,00,000 = 2:3

Comment: Higher ratio is the indicator of long term solvency position of the company.

Solvency ratio or ratio to total liabilities to total assets:

Solvency ratio = Total liabilities to outsiders / Total assets

Total liabilities are $4,00,000 and total assets are $8,00,000

Thus, 4,00,000 / 8,00,000 = 1:2

Lower the ratio of total liabilities to total assets, more satisfactory position of the firm.

Fixed assets to net worth ratio or Fixed assets to proprietors fund

This is useful in establishing relationship between fixed assets and shareholder’s fund i.e. share capital reserves and retained earnings.

Fixed -assets to Networth ratio = (Fixed Assets – Dep.) / Shareholder’s fund

The depreciated book value of fixed assets is $8,00,000 and shareholder’s fund is $4,00,000.

= 8,00,000 / 4,00,000 = 2:1

When this ratio indicates how the funds are used the best criteria is that fixed assets should be more than shareholder’s fund.

Ratio of current assets to proprietor’s fund

This ratio is calculated by dividing the total of current assets by the shareholder’s fund. Current assets are $4,00,000 and shareholder’s fund$8,00,000 the ratio would be:

= Current assets / Shareholder’s fund

= 4,00,000 / 8,00,000

= 1:2

This ratio speaks of the extent to which proprietor’s funds are invested in current assets.

Debt service Ratio or Interest coverage Ratio.

This ratio is a test of debt serving capacity of a firm. This is popularly known as interest coverage ratio or fixed charges cover. This ratio is calculated by dividing (EBIT) Earning before tax and interest by Fixed Interest Charges.

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Interest coverage ratio = Net profit (EBIT) / Fixed interest charges

Example

The net profit (after tax) of a corporate is $1,50,000 and its fixed interest on long term borrowing is $20,000. The rate of income tax is 60%. Calculate interest coverage ratio.

Interest coverage ratio = Net profit (EBIT) / Fixed interest charges

= (1,50,000 + tax 90,000 + interest 20,000) / 20,000

= $2,60,000 / 20,000

= 13 times

Example

The earnings before interest and taxes are $15,00,000. The details of the borrowings are:

12% long term loan: 30,00,000
Working Capital:
Borrowing 15% from Bank: $25,00,000
Public borrowing 10%: $20,00,000

The sale of the company is increasing and thus, company needs further borrowing from bank worth $20,00,000. The EBIT will increase by 25%. Calculate the change in interest coverage ratio after the additional borrowing.

Solution

Interest on borrowing$
(i) Long term loan 12% on 30,00,0003,60,000
(ii) Bank borrowing 15% on 25,00,0003,75,000
(iii) Public borrowing on 10% on 20,00,0002,00,000
Total Interest payable9,35,000

Interest coverage ratio = EBIT / Total interest liability

= 15,00,000 / 9,35,000 = 1.60 times

When additional borrowing of $20,00,000 is taken:

(20,00,000 x 15) / 100 = 3,00,000 (interest)

Thus, interest liability will be 9,35,000 + 3,00,000 = 12,35,000

Tax will increase by 25%

Thus, (15,00,000 x 20) / 100 = $3,00,000

= 15,00,000 + 3,00,000

= $18,00,000

New Change rates = 18,00,000 / 12,35,000 = 1.45 times

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