Ratio Analysis is a quantitative method of gaining insight into a company’s liquidity, operational efficiency, and profitability by studying its financial statements. It involves calculating, interpreting, and presenting the numerical relationship between two accounting figures (e.g., Current Assets vs Current Liabilities) to assess the financial health of the business.

Accounting ratios are broadly classified into four main functional categories:

• Liquidity Ratios: Measure the firm’s ability to meet short-term obligations (e.g., Current Ratio, Quick Ratio).
• Solvency Ratios: Measure the firm’s ability to meet long-term debts (e.g., Debt-Equity Ratio).
• Activity (Turnover) Ratios: Measure how efficiently the firm uses its assets (e.g., Inventory Turnover Ratio).
• Profitability Ratios: Measure the overall performance and viability (e.g., Net Profit Ratio).

Turnover ratios establish the relationship between Revenue (Sales) or Cost of Revenue and various assets/liabilities:

The ability to satisfy long-term obligations is known as Solvency. The ratios used for this purpose include:

• Debt-Equity Ratio: Shows relationship between external debt and shareholder’s funds.
• Total Assets to Debt Ratio: Measures the safety margin available to long-term lenders.
• Proprietary Ratio: Shows the extent to which total assets are funded by owners.
• Interest Coverage Ratio: Measures the firm’s capacity to pay interest on its debts.

The Average Age of Inventory (Inventory Holding Period) indicates the average time inventory remains in the firm before being sold.

Reasons for analysis:

• Sales Efficiency: A shorter period implies strong demand and efficient sales.
• Cash Flow: It helps estimate the cash conversion cycle (how fast cash returns).
• Cost Management: Helps avoid overstocking costs (warehousing, insurance, obsolescence).

Liquidity Ratios measure the short-term solvency of a business, i.e., its ability to meet its current obligations (current liabilities) as and when they fall due. They provide insight into the firm’s liquidity position.

1. Current Ratio

It establishes the relationship between Current Assets and Current Liabilities.

Importance: It assesses the ability of the firm to pay its short-term debts. An ideal ratio is 2:1, indicating that current assets are twice the current liabilities, providing a safety margin.

2. Liquid Ratio (Quick Ratio / Acid Test Ratio)

It establishes the relationship between Liquid Assets and Current Liabilities.

Importance: It is a more rigorous test of liquidity than the Current Ratio. It measures the firm’s ability to pay immediate debts without relying on the sale of inventory (which takes time). An ideal ratio is 1:1.

The solvency position of a firm refers to its ability to meet its long-term obligations. This is studied using Solvency Ratios, which analyze the relationship between external debt and internal equity/assets.

The key ratios used to study solvency are:

1. Debt-Equity Ratio: Measures the extent of debt financing relative to equity. (Total Debt / Shareholder’s Equity).
2. Total Assets to Debt Ratio: Measures the safety margin available to lenders by comparing assets to debt. (Total Assets / Total Long-term Debt).
3. Proprietary Ratio: Shows the proportion of total assets funded by the owners. (Shareholder’s Funds / Total Assets).
4. Interest Coverage Ratio: Indicates how many times the firm’s profits cover the interest obligations. (Profit Before Interest & Tax / Interest on Long-term Debt).

Profitability ratios measure the efficiency and success of the business in generating profit relative to sales, capital employed, or assets. The major ratios are:

1. Gross Profit Ratio

Measures the margin of profit on direct manufacturing/trading operations.

2. Operating Ratio

Measures the cost of operating activities relative to revenue.

3. Operating Profit Ratio

Measures the operating profit generated from core business activities.

4. Net Profit Ratio

Measures the overall profitability after all expenses and taxes.

5. Return on Investment (ROI)

Measures the return generated on the total capital invested.

This statement highlights the critical difference between the Current Ratio and the Quick (Liquid) Ratio based on the nature of Inventory.

The Logic:

• Standard Scenario (Illiquid Inventory): Typically, inventory is considered the least liquid current asset because it must first be sold (converted to debtors) and then collected (converted to cash). In this case, the Quick Ratio is preferred because it excludes inventory and tests immediate paying capacity.
• Liquid Inventory Scenario: If a firm’s inventory is highly liquid (e.g., fast-moving consumer goods or gold) and can be converted to cash instantly without loss of value, excluding it (via Quick Ratio) underestimates the firm’s liquidity. In this specific case, the Current Ratio (which includes inventory) provides a more accurate (“better”) measure of overall resources available to pay debts.

Conclusion:

The choice between the two ratios depends on the liquidity of the inventory. If inventory is stuck or slow-moving (Hard to convert), the Current Ratio is misleadingly high, and the Quick Ratio is safer. If inventory is as good as cash, the Current Ratio is a valid measure of liquidity.