Give the formulas to calculate the following ratios. Also, explain how to interpret them. i) Current Ratio ii) Quick Ratio iii) Average Collection Period iv) Time Interested Earned v) Inventory turnover

Give-the-formulas-to-calculate-the-following-ratios.-Also-explain-how-to-interpret-them.-i-Current-Ratio-ii-Quick-Ratio-iii-Average-Collection-Period-iv-Time-Interested-Earned-v-Inventory-turnover

CSS Solved Business Administration Past Papers | Give the formulas to calculate the following ratios. Also, explain how to interpret them. i) Current Ratio ii) Quick Ratio iii) Average Collection Period iv) Time Interested Earned v) Inventory turnover

The following question is attempted by Miss Nimra Masood, the top scorer in CSS Business Administration papers. Moreover, the answer is written on the same pattern, taught by Sir to his students, scoring the highest marks in compulsory subjects for years. This solved past paper question is uploaded to help aspirants understand how to crack a topic or question, how to write relevantly, what coherence is, and how to include and connect ideas, opinions, and suggestions to score the maximum.

Topic Breakdown:

The financial Ratios part is the crux of financial accounting. Be it calculation or its interpretation students need to be very clear, precise, and to the point in order to score maximum marks.

Chapter: Financial Statement Analysis
Subject: Financial Ratios.

Introduction:

Financial management is the most extensive, technical, and crucial part of business management. No business can survive without having an analysis of its financial Position. The finance part is divided into four main categories: Financial Statement, Budgeting, Time Value of Money, and Valuation. This question deals with the analysis of financial statements depicting the true picture of companies’ financial standing.

i) Current Ratio:

  • Formula
  • Interpretation
  1. Current Assets
    Those assets that can be quickly converted into cash are called current assets. They include cash in hand, accounts receivable, marketable securities and inventory.
  1. Current Liability

Those debts that are to be paid off in the very near future are called current liability. They include Accounts payable, accruals, and other short-term liabilities.

The current ratio is a part of the liquidity ratio, which is the firm’s ability to meet its short-term obligations. The current ratio in simplest of words it the ability of company to meet its current liabilities with current assets. The greater it is better it is for the company.  This ratio must be as a crude measure as it does not take into account the liquidity of individual components.  Firms consisting primarily of inventories are considered as less liquid.

ii) Quick Test Ratio:

  • Formula
  • Interpretation

Also part of the liquidity ratio. It shows a firms ability to meet current liabilities with its most liquid assets. This ratio serves as a supplement to the current ratio to give a clear indication of liquidity.  It is more penetrating then the current ratio but final opinion should be reserved until liquidity ratios are looked in to.

iii) Average Collection Period:

  • Formula:
  • Interpretation:

Receivable turnover gives us an overview as to firms quality of receivables. Also it provides information about the company’s success in collecting its outstanding dues.  This ratio is part of the activity ratio, which provides insight about the firms efficiency to utilize its assets. The average collection period tells us the number of days taken to collect all receivables. This ratio relies heavily on the industry average which would illustrate trends of other companies in the industry.

iv) Times Interest Earned

  • Formula:
EBIT: Earning before Interest and Taxes (also known as operating income)
  • Interpretation:

This ratio is part of the coverage ratio, which are the financial charges of a firm to its ability to service or cover them. Times interest earned shows the firms ability to cover its interest charges. It is also seen as a measure to avoid bankruptcy. Coverage ratios alone do not provide a comprehensive view of the company position therefore they are seen in coordination with the debt ratios.

v) Inventory Turnover

  • Formula:   
  • Interpretation:

This ratio is also a part of the activity ratio, which provides insight into the firms efficiency to utilize its assets.  The inventory turnover ratio determines how effectively the individual utilizes its inventory.  Higher the inventory turnover ratio, the better it is. It indicates that firm has good liquidity and stock is being updated frequently. Meaning it is the confidence in firms inventory management system.

Conclusion:

Financial ratios are the overview of the company’s standing. To have a clear understanding of the company’s financial standing company ratios are compared with the industry averages. Stakeholders have a close look at the financial ratios of company to evaluate the future of their investment. For this reason financial ratios are of dire importance for any business that desires to attract outside investment.

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