Question

Explain and illustrate any two of the following ratios used in the interpretation of
published accounts of companies:

Answer 1

Answer:

Current ratio (also known as working capital ratio) is a popular tool to evaluate short-term solvency position of a business. Short-term solvency refers to the ability of a business to pay its short-term obligations when they become due. Short term obligations (also known as current liabilities) are the liabilities payable within a short period of time, usually one year.

Formula:-

Current ratio is computed by dividing total current assets by total current liabilities of the business.

Example:-

Marshal company shows the total current assets of $1,100,000 and the total current liabilities of $400,000. Your are required to compute current ratio of the company.

Solution

Current ratio = Current assets/Current liabilities

= $1,100,000/$400,000

= 2.75 times

The current ratio is 2.75 which means the company’s currents assets are 2.75 times more than its current liabilities.

Liquidity comparison of two or more companies with same current ratio:-

We may find situations where two or more companies have the same current ratio figures but their real liquidity position is far different from each other. It happens because of the quality and nature of individual items that make up the total current assets of the companies. Consider the following example to understand this point in more detail:

Example:-

The following data has been extracted from the financial statements of two companies – company A and company B.

comparison of two companies with same current ratio.