Accounting Ratios

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1. Definition

Quick Ratio, also known as Acid Test Ratio, shows the ratio of cash and other liquid resources of an organization in comparison to its current liabilities.

2. Formula

Quick Ratio	=	Cash in hand + Cash at Bank + Receivables + Marketable Securities
		Current Liabilities

3. Explanation

Quick ratio shows the extent of cash and other current assets that are readily convertible into cash in comparison to the short term obligations of an organization. A quick ratio of 0.5 would suggest that a company is able to settle half of its current liabilities instantaneously.

Quick ratio differs from current ratio in that those current assets that are not readily convertible into cash are excluded from the calculation such as inventory and deferred tax credits since conversion of such assets into cash may take considerable time.

Quick ratio may therefore alternatively be calculated as follows:

Quick Ratio	=	Current Assets - Inventory - Advances - Prepayments
		Current Liabilities

Advances to suppliers and prepayments may be excluded from the calculation as they do not result in inflow of cash resources in the future that may be used to settle liabilities.

4. Example

ABC PLC has the following assets and liabilities as at 31st December 2012:

	$m	$m
Non Current Assets
Goodwill	75
Fixed Assets	75	150
Current Assets
Cash in hand	25
Cash in bank	50
Short term investments (Note 1)	75
Inventory	25
Receivable	100	275
Current Liabilities
Trade payables	100
Income tax payables	60	160
Non Current Liabilities
Bank Loan	50
Deferred tax payable	25	75

Note 1:

Short term investments include treasury bills amounting $45 million and investment in unlisted shares amounting $30 million.

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Quick ratio will be calculated as follows:

Quick Ratio	=	Cash in hand + Cash at Bank + Receivables + Marketable Securities
		Current Liabilities

	=	25+50+45	=	0.75
		160

5. Variations

In industries which typically have long receivables recovery duration such as in the construction sector, it may be appropriate to calculate the quick ratio by excluding receivables from the numerator to give a more suitable evaluation of the company's liquidity.

6. Interpretation & Analysis

Quick ratio is an indicator of solvency of an entity and must be analyzed over a period of time and also in the context of the industry the company operates in.

Generally, companies should aim to maintain a quick ratio that provides sufficient leverage against liquidity risk given the level of predictability and volatility in a specific business sector among other considerations. The more uncertain the business environment, the more likely that companies would maintain higher quick ratios. Conversely, where cash flows are stable and predictable, companies would seek to keep quick ratio at relatively lower levels. In any case, companies must achieve the right balance between liquidity risk arising from a low quick ratio and the risk of loss resulting from a high quick ratio.

A quick ratio that is greater than industry average may suggest that the company is investing too many resources in the working capital of the business which may more profitably be used elsewhere. If a company has too much spare cash, it may consider investing the surplus funds in new ventures and in case company is out of investment options it may be prudent to return the excess funds to shareholders in the form of increased dividend payments.

Acid test ratio which is lower than the industry average may suggest that the company is taking too much risk by not maintaining an appropriate buffer of liquid resources. Alternatively, a company may have a lower quick ratio due to better credit terms with suppliers than the competitors.

When analyzing the quick ratio over several periods, it is important to take into account seasonal variations in some industries which may cause the ratio to be traditionally higher or lower at certain times of the year as seasonal businesses experience irregular bursts of activities leading to varying levels current assets and liabilities over time.

7. Industry standards

Acid test ratio must be assessed in the context of the specific industry of an organization.

Certain business sectors traditionally have a very low quick ratio such as the retail sector. Companies leading the retail sector are able to negotiate very favorable credit terms with suppliers due to their dominance in the market leading to relatively high current liabilities in comparison to their liquid assets. The business environment is also relatively stable in the retail sector and the expansion of operations is incremental which allow such companies to maintain lower acid test ratios without taking too much risk.

As per 2011 annual reports, quick ratios of Wal-Mart Stores, Inc and Tesco PLC were 0.2 and 0.29 respectively.

Conversely, industries which expand at a very fast pace require higher levels of liquid resources at their disposal to satisfy their investment needs. Examples of companies operating in such industries include the fast food giants such as McDonald's and Burger King. Such companies require high levels of liquid assets to finance the growth in operations achieved through collaboration with franchisees.

As per 2011 annual reports, quick ratios of McDonald's Corporation and Burger King Holdings, Inc. were 1.05 and 1.30 respectively.

8. Importance

Quick ratio is a measure of a company's ability to settle its current liabilities on a very short notice. Current ratio may provide a misleading indication of a company's liquidity position when a considerable portion of its current assets is illiquid. Quick ratio is therefore a more reliable measure of liquidity for manufacturing companies and construction firms that have relatively high levels of inventory, work in progress and receivables.

http://accounting-simplified.com/financial/ratio-analysis/quick-acid-test.html#formula

1. Definition

Interest Coverage Ratio, also known as Times Interest Earned Ratio (TIE), states the number of times a company is capable of bearing its interest expense obligation out of the operating profits earned during a period.

2. Formula

Interest Cover Ratio	=	Profit before interest and tax (PIBT)
		Interest Expense

3. Explanation

Interest Coverage Ratio indicates the capacity of an organization to pay its interest obligations. An interest cover of 2 implies that the entity has sufficient profitability to bear twice the amount of its current finance cost.
The effect of taxation is normally ignored in the interest cover calculation to facilitate a better comparison of the contribution of the company's underlying profitability towards meeting its interest obligations which may be blurred to an extent by the effects of revision in tax rates, policies and prior period tax adjustments over several accounting periods.

4. Example

ABC PLC has the following financial results for the year ended 31st December 2012:

	$m
Sales	200
Cost of sales	110
Gross Profit	90
General and administration	(20)
Finance cost (Note 1)	(30)
Profit before tax	40
Taxation	(10)
Profit after tax	30

Note 1: Finance Cost

Finance cost comprises the following expenses:

$m

Days Sales in Inventory The days sales in inventory calculation, also called days inventory outstanding or simply days in inventory, measures the number of days it will take a company to sell all of its inventory. In other words, the days sales in inventory ratio shows how many days a company's current stock of inventory will last. This is an important to creditors and investors for three main reasons. It measures value, liquidity, and cash flows. Both investors and creditors want to know how valuable a company's inventory is. Older, more obsolete inventory is always worth less than current, fresh inventory. The days sales in inventory shows how fast the company is moving its inventory. In other words, it shows how fresh the inventory is. This calculation also shows the liquidity of inventory. Shorter days inventory outstanding means the company can convert its inventory into cash sooner. In other words, the inventory is extremely liquid. Along the same line, more liquid inventory means the company's cash flows will be better. Formula The days sales inventory is calculated by dividing the ending inventory by the cost of goods sold for the period and multiplying it by 365.

Ending inventory is found on the balance sheet and the cost of goods sold is listed on the income statement. Note that you can calculate the days in inventory for any period, just adjust the multiple.
Since this inventory calculation is based on how many times a company can turn its inventory, you can also use the inventory turnover ratio in the calculation. Just divide 365 by the inventory turnover ratio
Days inventory usually focuses on ending inventory whereas inventory turnover focuses on average inventory.

Analysis

The days sales in inventory is a key component in a company's inventory management. Inventory is a expensive for a company to keep, maintain, and store. Companies also have to be worried about protecting inventory from theft and obsolescence.
Management wants to make sure its inventory moves as fast as possible to minimize these costs and to increase cash flows. Remember the longer the inventory sits on the shelves, the longer the company's cash can't be used for other operations.
Management strives to only buy enough inventories to sell within the next 90 days. If inventory sits longer than that, it can start costing the company extra money.
It only makes sense that lower days inventory outstanding is more favorable than higher ratios.

Example

Keith's Furniture Company's management have been extremely happy with their sales staff because they have been moving more inventory this year than in any previous year. At the end of the year, Keith's financial statements show an ending inventory of $50,000 and a cost of good sold of $150,000. Keith's days sales in inventory is calculated like this:

As you can see, Keith's ratio is 122 days. This means Keith has enough inventories to last the next 122 days or Keith will turn his inventory into cash in the next 122 days. Depending on Keith's industry, this length of time might be short or long.

Bank Charges

5

Unwinding of discount on provisions

5

Interest cost on short term and long term borrowings

20

30

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Interest Coverage may be calculated as follows:

Interest Coverage	=	Profit before interest & tax	=	40 + 30	=	3 times
		Interest expense		20*

*Interest cost used in calculating interest coverage includes only the interest expense incurred on loans and other financing arrangements but does not include accounting expense recognized in respect of unwinding of discount on the recalculation of present value of provisions.

5. Interpretation & Analysis

Loans and borrowings are cheap source of finance primarily because the interest cost is usually tax deductible in most jurisdictions unlike dividend payments. However, interest costs are obligatory payments unlike dividend payouts which are discretionary upon management's intent. Therefore, the level of debt financing must be at an acceptable level and should not exceed the point which exposes an organization to unacceptably high financial risk as might be reflected in a low interest cover.
Generally, companies would aim to maintain an interest coverage of at least 2 times. Interest cover of lower than 1.5 times may suggest that fluctuations in profitability could potentially make the organization vulnerable to delays in interest payments.
A very high interest cover may suggest the fact that the company is not capitalizing on the relatively cheaper source of finance (i.e. debt) and in such instances an increase in gearing ratio may actually add value to the enterprise.
Companies operating in industries that are exposed to a high level of business risk and uncertainty would generally prefer to maintain lower level of financial risk (by lower debt financing) and higher interest cover ratios. Most IT related startup companies prefer equity financing through venture capital institutions rather than loan financing due to the high level of risk involved and such companies would tend to have very high interest coverage ratios.
When analyzing interest coverage trend over several accounting periods, it is important to consider significant changes in the level of borrowings since the full extent of such changes on future interest cover may not be entirely revealed due to the effect of additional borrowings or repayments of loans close to end of accounting periods.

7. Importance

Interest Coverage Ratio is a measure of the capacity of an organization to honor it interest obligations.
Interest coverage is an indication of the margin of safety for an organization before it runs the risk of non-payment of interest cost which could potentially threaten its solvency. Although profitability is not absolutely essential to maintain liquidity in the short term, profitability of operations is crucial to enable an organization to meet its debt servicing obligations in the long run. Management may also use interest cover ratio to determine whether further debt financing can be undertaken without taking unacceptably high financial risk.
Potential lenders and investors assess the interest cover ratio to determine the level of security and risk associated with their investment or lending to the organization. Interest cover ratio is also a regular feature of loan covenants requiring borrowers to maintain a minimum level of interest cover failing which may impose the immediate settlement of debt.

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