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CBSE Class 12 Commerce Accountancy Liquidity Ratios Complete Notes

CBSE Class 12 Commerce Accountancy Liquidity Ratios Complete Notes

CBSE Class 12 Commerce Accountancy Liquidity Ratios : The CBSE board conducts several examinations including AISSCE for class 10 and 12. AIEEE (All India Engineering Entrance Examination) and AIPMT (All India Pre medical Test) are also conducted by this board. Through AIEEE, students take admission in engineering and architecture in different colleges whereas AIPMT enables students to take admission in medical colleges in India. For the better understanding of students, this board makes  CBSE Class 12 Commerce Accountancy Liquidity Ratios Notes available in our website  that students can take these as per their requirement.

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CBSE Class 12 Commerce Accountancy Liquidity Ratios Complete Notes

CBSE Class 12 Commerce Accountancy Liquidity Ratios : Liquidity ratios measure a company’s ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick ratio and operating cash flow ratio. Current liabilities are analyzed in relation to liquid assets to evaluate the coverage of short-term debts in an emergency. Bankruptcy analysts and mortgage originators use liquidity ratios to evaluate going concern issues, as liquidity measurement ratios indicate cash flow positioning.

BREAKING DOWN ‘Liquidity Ratios’

CBSE Class 12 Commerce Accountancy Liquidity Ratios : Liquidity ratios are most useful when they are used in comparative form. This analysis may be performed internally or externally. For example, internal analysis regarding liquidity ratios involves utilizing multiple accounting periods that are reported using the same accounting methods. Comparing previous time periods to current operations allows analysts to track changes in the business. In general, a higher liquidity ratio indicates that a company is more liquid and has better coverage of outstanding debts.

Alternatively, external analysis involves comparing the liquidity ratios of one company to another company or entire industry. This information is useful to compare the company’s strategic positioning in relation to its competitors when establishing benchmark goals. Liquidity ratio analysis may not be as effective when looking across industries, as various businesses require different financing structures. Liquidity ratio analysis is less effective for comparing businesses of different sizes in different geographical locations.

Solvency Versus Liquidity

CBSE Class 12 Commerce Accountancy Liquidity Ratios : Solvency relates to a company’s overall ability to pay debt obligations and continue business operations, while liquidity focuses more on current financial accounts. A company must have more total assets than total liabilities to be considered solvent and more current assets than current liabilities to be considered liquid. Although solvency is not directly correlated to liquidity, liquidity ratios present a preliminary expectation regarding the solvency of a company.

Examples of Liquidity Ratios

CBSE Class 12 Commerce Accountancy Liquidity Ratios : The most basic liquidity ratio or metric is the calculation of working capital. Working capital is the difference between current assets and current liabilities. If a business has a positive working capital, this indicates it has more current assets than current liabilities and in the event of an emergency, the business can pay all of its short-term debts. A negative working capital indicates that a company is liquid.

The current ratio divides total current assets by total current liabilities. This ratio provides the most basic analysis regarding the coverage level of current debts by current assets. The quick ratio expands on the current ratio by only including cash, marketable securities and accounts receivable in the numerator. The quick ratio reflects the potential difficulty in selling inventory or prepaid assets in the result of an emergency.

CBSE Class 12 Commerce Accountancy Liquidity Ratios Complete Notes

CBSE Class 12 Commerce Accountancy Liquidity Ratios : Liquidity ratios analyze the ability of a company to pay off both its current liabilities as they become due as well as their long-term liabilities as they become current. In other words, these ratios show the cash levels of a company and the ability to turn other assets into cash to pay off liabilities and other current obligations.

Liquidity is not only a measure of how much cash a business has. It is also a measure of how easy it will be for the company to raise enough cash or convert assets into cash. Assets like accounts receivable, trading securities, and inventory are relatively easy for many companies to convert into cash in the short term. Thus, all of these assets go into the liquidity calculation of a company.

Significance of Liquidity Ratios or Analysis of Liquidity:

Liquidity ratios play a key role in assessing the short-term financial position of a business. Commercial banks and other short-term creditors are generally interested in such an analysis.

However, managements can employ these ratios to ascertain how efficiently they utilize the working capital in the business. Shareholders and debenture holders and other long-term creditors can use these ratios to assess the prospects of dividend and interest payments.

This type of ratios normally indicates the ability of the business to meet the maturing or current debts, the efficiency of the management in utilizing the working capital, and the program attained in the current financial position.

CBSE Class 12 Commerce Accountancy Liquidity Ratios :

Principal Liquidity Ratios:

Current Ratio:

Meaning:

Current Ratio may be defined as the ratio of current assets to current liabilities. It is also known as Working Capital Ratio or 2:1 Ratio. It shows the relationship between the total current assets and total current liabilities, expressed as formula given below:

Current Ratio

Components:

Current assets mean cash or those assets convertible or expected to be converted into cash within the accounting year, and current liabilities are those liabilities to be paid within the same time.

Current assets normally include the following items:

CBSE Class 12 Commerce Accountancy Liquidity Ratios : Cash in hand and at bank, Marketable Securities or readily realizable investments, Bills Receivable, Book Debts (excluding bad debts and provision), Inventories and Prepaid Expenses. Current Liabilities include items such as Outstanding or Accrued Expenses, Sundry Creditors, Bills Payable, Bank Overdraft, Provision for Taxation, etc.

General Guidelines:

CBSE Class 12 Commerce Accountancy Liquidity Ratios : All current assets and current liabilities should be properly valued. Therefore all reserves and provisions created should be deducted from such current assets. Book debts outstanding for more than 6 months and loose tools should be excluded.

Investments, which are easily marketable and are meant to be sold for cash should be treated as current assets. Even long-term liabilities, if they are repayable within the accounting year, should be treated as current liability.

Bank overdraft, unless specifically stated as a permanent arrangement, should be treated as a current liability. As regards bills receivable, all bills (whether discounted or not) should be treated as current asset and at the same time, discounted bills receivable should be treated as current liability.

Example 1:

From the following compute the Current Ratio:

Excerpt form a Balance Sheet

Total current assets Rs. 1, 25,000 (loose tools should be excluded). Total current liabilities Rs.75, 000.

Current Ratio = clip_image006 = 1.67 or 5: 3

Interpretation:

CBSE Class 12 Commerce Accountancy Liquidity Ratios : From the above ratio, it is clear that for every rupee worth of current liabilities, there are current assets worth Rs.1.67. In other words, it connotes that the firm can meet all it’s current obligations even by just realizing 60% of its current assets.

Though 2: 1 is often referred to as a banker’s rule of thumb standard of liquidity for a business, it is suggested that an ideal current ratio could be between 1.5: 1 to 2: 1.

Significance of Current Ratio:

Current ratio is an index of the firm’s financial stability, i.e., an index of technical solvency and an index of the strength of working capital, which means excess of current assets over current liabilities.

The logic behind the current ratio is that cash need not be immediately available to meet all current liabilities on a particular date but there should be good prospects for an adequate inflow of cash indicated by the amounts of individual components of current assets.

It is closely connected with the concept of working capital. A high current ratio is an assurance that a firm will have adequate funds to pay current liabilities and other current payments.

However, the main limitation of current ratio is that it fails to indicate the liquidity of individual components of current assets.

For example, a high current ratio due to large inventories may not be regarded as an index of liquidity as one that is due to huge cash and bank balances.

Even if the ratio is favorable, the firm may be in financial trouble because of more stock and work in progress, which are not easily convertible into cash and therefore, may have less cash to pay off current liabilities.

Hence, it is suggested that the current ratio should not be used as the sole index of short-term solvency.

Liquid Ratio:

Meaning:

CBSE Class 12 Commerce Accountancy Liquidity Ratios : Liquid Ratio may be defined as the ratio of liquid assets to liquid liabilities or current liabilities. It is concerned with the relationship between liquid assets and liquid or current liabilities.

The other terms used for liquid ratio are ‘Quick ratio’ and ‘Acid Test Ratio’. For the purpose of computation, the current assets and current liabilities could be classified as follows:

Current Assets:

(a) Liquid Assets, and

(b) Deferred Assets.

Current Liabilities:

(a) Liquid Liabilities, and

(b) Deferred Liabilities.

Establishing a simple rule that all assets and liabilities are liquid if they are expected to be realized or paid within a month could make this classification, otherwise they belong to ‘deferred’ category.

However, the criterion for such classification depends upon the purpose for which the liquid ratio is used.

Components:

Liquid assets normally include cash, bank, sundry debtors, bills receivable, and short-term investments or marketable securities. In other words, they are current assets minus inventories and prepaid expenses.

In the same manner, liquid liabilities are current liabilities minus bank overdraft and income received in advance.

The formula is as follows:

Liquid Ratio

Some authorities recommend that liquid ratio may be computed comparing current liabilities with liquid assets.

General Guidelines:

All guidelines that are applicable to the computation of current ratio are equally applicable to the computation of liquid ratio. That is, current assets and current liabilities should be properly valued and the nature of assets should be kept in view.

Example 2:

From the figures given in Example 1, the liquid ratio may be calculated as follows:

Liquid assets = Current assets minus inventory and prepaid expenses.

= Rs. 1, 25,000 minus (Rs.44, 000 + Rs.5,000) = Rs.76,000

Liquid liabilities = Current liabilities minus Bank overdraft

= Rs.75, 000 minus Rs.35,000 = Rs.40,000

Liquid Ratio

Interpretation:

The ratio indicates that by realizing the debtors, short-term investments and bills receivables at their face values along with cash and bank balances, the firm could pay off all liquid liabilities.

In other words, the firm could meet its liquid liabilities without resorting to the sale of inventories. Comparing with the standard ratio of 1:1 for liquid ratio, the actual ratio i.e., 1.9:1 is exceptionally good.

However, maintaining very high ratio continuously may also indicate too much of idle cash resources.

Significance of Liquid Ratio:

Liquid Ratio is a more rigorous test of liquidity than current ratio. A comparison of current ratio with liquid ratio would indicate the degree of inventory held up.

A high liquid ratio compared to current ratio may indicate under-stocking while a low liquid ratio may indicate over-stocking.

When used in conjunction with current ratio, the liquid ratio gives a better picture of the firm’s capacity to meet its short-term obligations out of short-term assets. However, it is difficult to establish a standard without further investigation.

A reasonable standard for the liquid ratio may vary from season to season and also from business to business. For example, a manufacturing company may have a weak liquid ratio in time of prosperity, for increased activity may result in huge stocks and holding of less cash.

Hence, it should be remembered while arriving at conclusions that though technically inventories are not immediately available to meet current liabilities, to some extent, they do generate cash during normal course of business.

Inventories are converted into cash, debtors, and bills receivable when they are sold in the ordinary course of business. Though this ratio is an improvement over current ratio, the interpretation of this ratio also suffers from the same limitations of current ratio.

Absolute Liquidity Ratio:

Absolute liquidity is represented by cash and near cash items. Hence, in the computation of this ratio, only absolute liquid assets are compared with liquid liabilities.

These assets normally include cash, bank, and marketable securities. It is to be observed that receivables are excluded from the list of liquid assets.

Formula:

Absolute Liquidity Ratio

This ratio gains significance only when it is used in conjunction with the first two ratios. A standard of 0.5: 1 is considered an acceptable norm for this ratio.

In other words, this ratio indicates that 50 paise worth of absolute liquid assets are sufficient to meet one rupee worth of liquid liabilities. However, this ratio is not in much use.

The Current Ratio, Liquid Ratio and Absolute Liquidity Ratio generally indicate the adequacy of current assets for meeting current liabilities. This is one dimension of liquidity analysis.

The other dimension of liquidity is the determination of the rate at which various short-term assets are converted into cash. Important ratios under the secondary category are as follows:

Debtors Turnover Ratio:

Debtors or Receivables normally include both sundry debtors and bills receivable (B/R) and represent uncollected portion of credit sales. Turnover, here, refers to credit sales.

Receivables constitute an important component of current assets and therefore the quality of receivables determines the liquidity of a firm to a greater extent.

This ratio can be calculated in two ways as follows:

Debtors Turnover Ratio

Components:

Book debts and B/R, which arise out of credit sales, should be considered. Adding opening and closing balances of Book Debts and B/R and then dividing the result by two can arrive at average amount.

It should be noted that provision for bad and doubtful debts should not be deducted since it may give the impression that some amount of receivable has been collected. When credit sales figure is not given the total sales may be considered for computation.

The Receivables Turnover Ratio, when calculated in terms of days or months, is known as Average Collection Period or Debts Collection Period.

Example 3:

From the following details compute Debtors Turnover Ratio and Average Collection Period:

Debtors Turnover Ratio and Average Collection Period

Solution:

Debtors Turnover Ratio and Average Collection Period

(It may be assumed for the number of days in a year as 360 or 365)

In fact these two ratios are inter-related. Debtors Turnover Ratio could be obtained by dividing the number of days in a year by the average collection period (i.e., 360 days/60 days = 6). It may be noted that provision for doubtful debts has not been considered for computation.

Significance:

Average collection period indicates the quality of debtors by measuring the rapidity or slowness in the collection process. A shorter collection period implies prompt payment by debtors, while longer period implies a too liberal and inefficient credit collection performance.

In order to measure the efficiency of the credit collection department this should be compared with the average of the industry. It should be neither too liberal nor too restrictive.

When a liberal credit policy may result in more bad debts and over-investment in receivables, a restrictive policy may result in lower sales and resultant lower profits.

It is very difficult to establish a standard collection period since it depends on a number of factors such as the seasonal character of the business, nature of industry, credit policy of the firm, etc.

However, it is a good supplementary check to be used for judging the adequacy of current ratio.

Creditors Turnover Ratio:

This ratio is similar to Receivables Turnover Ratio. It compares the Accounts Payable with the total credit purchases. It signifies the credit period enjoyed by the firm in paying creditors.

Accounts Payable include both sundry creditors and bills payable (B/P). It is calculated as follows:

Creditors Turnover Ratio

Example 4:

From the following particulars, compute the Creditors Turnover Ratio:

Creditors Turnover Ratio

Solution:

Creditors Turnover Ratio

Significance:

A high creditors turnover ratio signifies that the creditors are being paid promptly thus boosting up the credit worthiness of the firm. A very low ratio may signify that the firm is not taking full advantage of credit facilities allowed by the creditors.

Inventory Turnover Ratio:

Meaning:

Inventory Turnover Ratio is a ratio that establishes the relationship between Cost of Sales and Average Inventory. It is also known as Stock Turnover Ratio. This ratio indicates whether the investment in inventory is within proper limit or not.

Besides being an index of liquidity of a firm showing the rate at which inventories are converted into sales and then into cash, this ratio helps the finance manager to evaluate the inventory policy.

Components:

CBSE Class 12 Commerce Accountancy Liquidity Ratios : Average inventory and Cost of goods sold are the constituents of the ratio. When monthly inventory figures are available, the average inventory is calculated by taking the inventory level at the opening date plus inventory levels at the end of each month, adding them up and then dividing by thirteen.

If the monthly figures are not available, then adding could derive the average inventory stock levels at the opening and closing dates and dividing by two. As regards sales, the ratio is best expressed when the average inventory is compared with the cost of goods sold.

However, when cost of goods is not known, the ratio of net sales (sales less returns) to average inventory may be used as substitute.

Some firms, like departmental stores, which value inventories at selling price under retail method, may compute this ratio comparing net sales to average inventory at selling prices.

Formulae:

Stock Turnover Ratio can be calculated by employing any one of the following formulae:

Stock Turnover Ratio

Stock Turnover Ratio

To be more realistic the ratio should be calculated using the same units as numerator and denominator. Accordingly, the first (both in terms of cost) and third (both at selling price) formulae may be considered more logical.

However, the second one may be used where the cost of goods is not known. The fourth formula is useful mainly to eliminate the effect of changing prices.

When the inventory consists of more kinds of items such as raw materials, work in process and finished goods, it is useful to break up the inventory turnover ratio into its main constituent parts to bring out the efficiency or inefficiency at various points.

In such cases, the inventory turnover ratio and its constituent parts may be calculated as follows:

Investory Turnover Ratio

Note:

Average inventory is calculated by taking the stock levels of finished goods, raw materials, and work in process at the opening and closing dates.

Average Investory

Example 5:

From the following particulars calculate Stock Turnover Ratio:

Stock Turnover Ratio

Solution:

Stock Turnover Ratio

Significance:

CBSE Class 12 Commerce Accountancy Liquidity Ratios : Inventory Turnover Ratio is an effective tool to measure the liquidity of inventory and thereby to avoid any danger of overstocking as a prelude to the efficient utilization of a firm’s resources.

While a high Inventory Turnover Ratio indicates brisk sales, a low turnover ratio may reflect dull business, over -investment in inventory, accumulation of huge stocks, etc.

However, it should be remembered that these ratios, standing by themselves, mean absolutely nothing. Hence, for a meaningful analysis, they should be compared with similar ratios in the previous period, or with the ratio of other similar firms.

It is very difficult to establish standards for this ratio because it will differ from industry to industry. It is also an index of profitability, where a high ratio signifies more profit; a low ratio signifies low profit.

Sometimes a high inventory turnover ratio may not be accompanied by relatively high profits or profits may be sacrificed to push up sales volume by reducing selling price. Similarly a high turnover ratio may be due to under-investment in inventories.

Precautions:

The interpretation of inventory turnover ratio should always be done keeping in view the complex circumstances, which have a bearing upon the formulation of inventory policies.

When ratios fall out of standards, the reasons for such results should be ascertained, and then conclusions can be arrived at.

The following factors may be given due consideration while using the inventory turnover ratio:

Price trends:

Increasing or decreasing prices will have their influence on inventories.

Volume of business:

An increasing trend in the volume of business may necessitate large inventories, and vice versa.

Supply Conditions:

Scarcity conditions may compel firms to pile up stocks for future requirements.

Seasonal conditions:

The amount of inventory may differ between seasons. Hence, the nature of season, i.e., slack season or busy season to which the inventory value belongs, should be duly considered.

Cash Turnover Ratio:

This ratio relates the average cash and bank balances to the total cash and cheque payments. It will indicate whether the cash and bank balances are in tune with the actual payments.

Formula:

Cash Turnover Ratio

Significance:

CBSE Class 12 Commerce Accountancy Liquidity Ratios : This ratio measures the efficiency of cash management. A high ratio may indicate that the cash and bank balances kept are unduly low, while a low ratio may indicate that the balances are unduly high, which signifies inefficiency of cash management.

Establishing a standard is very difficult as it will be a matter for the management to decide about proper cash and bank balances, considering possible future requirements, which may vary from time to time, and from business to business.

CBSE Class 12 Commerce Accountancy Liquidity Ratios Complete Notes

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