Financial Ratios Essay Example

Financial Ratios

Current Ratio

Current ratio is a quotient of the short-term assets of company with the within one year liabilities and is used as an indicator of the liquidity of the company and is the indicator of the ability of the company to settle its short-term debts by depending on the current assets at its disposal. This ratio is calculated by the formula:

Current Ratio = Most liquid assets/ Within one year Liabilities

A company having a positive working capital, it means that the value of its current assets is greater than the value of the current liabilities.

The elements that have effects on the current ratio are those that fall under the short-term assets and short-term liabilities or in one way have a direct or an indirect effect on the two.

Generally the actions that lead to an increment in the short-term assets and reduction in the current liabilities result in to the improvement of the company’s liquidity which is the increase in the current ratio. In this case, payment of the supplier and repayment of a short-term bank loan are actions that lead to the reduction of the short-term liabilities. On the other hand, purchase of inventory and selling it at a profit and a customer repaying the credit increases the company’s current assets and this also increases the current ratio. The cost of selling inventory is likely to eat in to the profits and this reduces the current assets hence reducing the current ratio.

Current Ratio and Quick Ratio

The two ratios are the indicators of the capabilities that the company has to handle its within one year liabilities using the most liquid assets it has.

Quick Ratio = (Short-term assets – inventories) / Short-term liabilities

In a case where the current ratio is increasing and the quick ratio is falling, Dixie Co. is having an increase in the value of the inventory making the numerator smaller. The liquidity of the company has still improved.