Analysis of financial statements Part 3

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First we need to understand Money comes from owners are termed as Equity and money comes from outsiders are known as Liability. When money comes from outsiders comes with obligations to be repaid within one year or after one year. When it comes with obligation to be repaid within one year is called short term Liability. Taking advance in the form of Cash Credit, Overdraft, and advance from customers, you have the commitment either to repay them or deliver the goods. Using this money, generally one creates Short Term Assets.  

If you look at the proportion here, Short term assets are greater than Short term Liabilities. If one business is having Short term assets are greater than Short term liabilities, then the business is in comfortable position. So one can say Liquidity position is comfortable.



Let’s have an example, suppose a firm is having Short term assets of 15 Cr and is having Short term liabilities of 10 Cr. This means the company is in comfortable position or you can say liquidity position is comfortable as it is having 15 Cr short term assets to pay the current liability of 10 Cr.

FUND UTILISATION PRINCIPLE

Out of 100, 95% of businesses fail because they do not understand how to use their funds. The principle is very important from business man point of view as well as from banker’s point of view for the safety of the fund lent to the borrower.

If one firm has Short Term Assets are greater than Short term liabilities (SA>SL), then we may consider the firm is having comfortable position to meet the current obligations. Looking at below figure, we understand the fact that the Short term assets are greater than Short term liability that, means some portion of Short term assets are being funded from Long term liability or fund. The remaining long term funds are being utilized in creating long term assets. In this way we can break any balance sheet into 4 compartments and the most important part is that how these funds are going to be utilized?


  • ·   The business can use the short term fund to create short term assets that is good.
  • ·   The business can also use long term funds to create long term assets that is good.
  • ·   The business can also use the long term funds to create short term assets which can be termed as ideal.
  • ·   But business should never ever divert or use short term funds to create long term assets, which is suicidal.


CURRENT RATIO

·        If  the current ratio is 1, it means, the Current assets = Current liabilities

·     If it is more than 1, it means, some long term funds have been used to fund the current assets.

·       If the current ratio is 1, it means Net Working capital is Zero.

·      Generally CR 2 (2 Current assets and 1 current liability) is considered good current ratio.

·      In Indian conditions, 1.33 is considered an acceptable current ratio.

So in Scenario I, for every 1 rupee of current liability, 2 rupee of current assets are available.

In Scenario II, Both Current liability = Current assets, i.e. for every 1 rupee of liability, 1 rupee of current assets are available.

In Scenario III, for every 1 rupee of current liability, only 0.67 paise of current assets available, which is not desirable from banker’s point of view.


This indicates Out of 100% current assets, 25% are funded from long term fund or owner’s contribution.

·      Current ratio measures its short term solvency i.e. its ability to meet short term obligations

·       As a measure of short term/ Current financial liquidity, it indicates the rupees of current assets available for each rupees available per rupee of current liability.

·   The higher the CR, the larger is the amount of rupees available per rupee of current liability that is, the more is the firm’s ability to meet current obligation and the greater is the safety of funds of short term creditors.

·        Thus, CR is a measure of margin of safety to the creditors.

Problem with Current Ratio

·        Sometimes the CR may be acceptable, but realization from sale of stock may be slow and meeting a commitment may become difficult.

·        As current assets consist of items like ram material, finished goods, debtors etc. and not all of these are equally liquid; the CR is not always good tool to ascertain how good the liquidity is.

·        It is a quantitative rather than qualitative index of liquidity. CR takes the entire CA without making any distinction between various types of CAs such as cash, inventories and so on. More so, some CA is more liquid than others.

To answer these and related questions, an additional analysis of the quality of current asset is required. This is done in Acid-test or Quick ratio which we will read in next part of Analysis of Financial Statements.

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