When it comes to ascertaining the financial health of any business, the most basic technique deployed by financial analysts is the – Ratio Analysis. It is a systematic study of historical financial statements and arriving at the desired financial ratios to draw an inference. However, the focus of this article is not to simply list down the various types of ratio analysis techniques practiced out there, but also to make the reader aware that these ratios are not to be seen as a standalone technique to draw conclusions for decision makers. The businesses are being operated in a fairly complex backdrop, hence demand the analysts to take into consideration multiple data-points to put these numbers into context.
Ratio Analysis, in general, could be broadly divided into two categories – Internal and External. Internal analysts, chiefly the management, are interested in learning more about the performance of their business, make important financial decisions and take the business to new heights. Whereas the external analysts are mostly the potential investors and likes, and the source of data that they base their calculations upon is the published financial statements of the company.
One major drawback of the financial ratio analysis is the lack of any testable theory in the process of financial analysis. Unlike other scientific disciplines, Accounting has evolved in a haphazard manner and so are the ratio analysis techniques in this context. The fact that the accounting practices/structures in various firms and across industries are loosely based on GAAP (Generally Accepted Accounting Principles) causes a great contradiction to the work of financial analysts.
We are going to discuss further the most common of financial ratios – Liquidity Ratio, their advantages, and disadvantages, explained with the help of formulas used in each type of ratio analysis.
Liquidity Ratio Analysis
Liquidity Ratio of a business is determined by the state of its assets and liabilities. It is used to investigate a firm’s ability to meet its immediate debt obligations by liquidating the assets available at disposal. In a nutshell, in case any emergency presents itself, how the business will sustain it, in its current state, without an additional financial help. These aspects makes liquidity ratio is most crucial one among Financial ratio analysis.
Let’s say a potential investor wants to invest in a certain business, he would naturally want to secure his investment to the best possible extent by ensuring the financial health of the firm. And to do so, a study of liquidity ratios will provide such insight, on which the potential investor could base his decision to invest further in the said firm.
There are multiple approaches to calculating the liquidity ratios, namely –
- Current Ratio
- Quick Ratio or Acid Test
- Cash Ratio / Operating Cash Flow Ratio
- Interval Measure or the Burn Rate
Now, each of these approaches has their merits and demerits, let us look into them one at a time in the further text.
This is the simplest ratio among financial ratio analysis, as it assumes that all the current assets could be easily liquidated, so it takes into account all the mentioned current assets from the financial statement for the accounting period and divides it with all the current liabilities.
Hence the formula goes like –
Current Ratio = Current Assets / Current Liabilities
It gauges the immediate financial strength of the company. Higher the current ratio, more stable the company is. Lower the ratio, more the risk associated with the company. Another big advantage with current ratio is that it directly correlates with the company’s and management’s performance, and help the analysts learn the crucial aspect of the said company. How it correlates with the performance? Well, it is the ability of convert the inventory to cash in most efficient way. It tells about the operating cycle of the company, and if it is an investor researching this company, he would know that his investment will be in good hands.
The thing about Current Ratio is that it regards the current assets at face value, whereas it is an established fact that majority of listed assets will be evaluated differently depending upon a lot of variable aspects. So one can’t rely on the listed value of the assets point blank.
The inclusion of inventory in the current assets is another misleading aspect of it. As it attributes to various uncertain scenarios, how the inventory will be evaluated, e.g. seasonal products may be lying around in stock in offseason period and show higher numbers. Even the methods used in evaluation could also be misleading.
Quick Ratio or Acid Test
Quick Ratio, also referred as Acid Test, is a finer version of the current ratio. It eliminates the drawback of including the inventory in the calculation of the liquidity ratio hence better financial ratio analysis
Hence the formula now looks like –
Quick Ratio = (Cash & Equivalents + Short Term Investments + Accounts Receivables) / Current Liabilities
As stated earlier, the acid test does not take into account while calculating the liquidity ratio, so that obviously leads to giving us a more accurate conclusion of the liquidity state of the company. As the reader would know that the inventory could not always be considered as a liquid asset, so by excluding it a number of possible pitfalls are avoided. To name a few – bank overdraft/credit against inventory, valuation difference, seasonal sales, etc.
There are certain industries where the inventory holds a sizable proportion of assets due to the very nature of their business, for such companies, this liquidity ratio might not actually work. For example supermarkets.
Another demerit with this approach is that it lacks the element of time and level of cash inflow, which actually can tell a lot about the company’s financial stability.
Cash Ratio / Operating Cash Flow Ratio
In this approach, the ratio of current liability is calculated against the current income/cash equivalent rather than selling off any of the assets. It takes into account the assets that could be most easily used to pay off the immediate liabilities.
So here goes the new formula –
Cash Ratio = Cash & Equivalents / Current Liabilities
The calculation in this approach is really simple and direct. It builds on the fact that if there are liabilities in short term, the capacity to balance them off with the operating cash flow gives a fair picture of an entity’s financial position.
There are good chances that a company can manipulate the cash flow from operations and hence lead to a totally unreliable state of affairs. So one needs to be really careful while working on this approach and look deeply into all the facts laid out there and in reference to the accounting conventions used.
Interval Measure or the Burn Rate
Another aspect of financial ratio analysis is the interval measure approach takes into the consideration the previously ignored aspect of time and cash flow element while working out the liquidity ratio. This is actually a lot sensible because the concerned stakeholders will naturally be more inclined to learn about the return on their investment in terms of days instead of just knowing the financial stability of the firm in question.
So the formula for this one goes like –
Burn Rate = (Cash and Equivalent + Marketable Securities + Net Receivable) / *Daily Operational Expenses
*Daily Operational Expenses = (Annual Operating Expenses – Non-Cash Charges) / 365
A lot of financial analysts prefer this approach over other approaches simply because it compares the assets to expenses rather than liabilities and tells about the actual number of days a company can run without selling of current assets. It is more of a financial efficiency ratio.
The only shortcoming of the concept is that it can’t be relied upon as a standalone methodology to figure out an entity’s financial status. As we mentioned earlier in this article also that there are various factors working simultaneously to keep a business afloat, so by simply looking at one liquidity ratio, it might present a totally misleading picture to the onlooker. So, it is best to look at these numbers in a contextual manner and due consideration with factors like intuition, experience, and research.