Ratio analysis

Ratio analysis involves methods of calculating and interpreting financial ratios to assess the firm’s performance.  Ratio analysis of a firm’s financial statements is of interest to shareholders, creditors and firm’s own management.  Ratio analysis is the starting point in developing the information desired by the analyst. Ratio analysis provides only a single snapshot, the analysis being for one given point or period in time. In ratio analysis it is possible to compare the company ratio with a standard one. Ratio analysis can be classified as follows:

1. Liquidity ratio
2. Activity ratio
3. Profitability ratio
4. Debt-coverage ratio
5. Owner’s Ratio

Liquidity dimension

A firm's ability to pay its debts can be measured partly through the use of liquidity ratios. A firm should ensure that it does not suffer from lack of liquidity and also that it is not too much highly liquid. Short term liquidity involves the relationship between current assets and current liabilities. If a firm has sufficient net working capital (the excess of current assets over current liabilities), it is deemed to have sufficient liquidity. There are some ratios that are commonly used to measure liquidity directly, they are:

1. Current ratio
2. Quick ratio or acid test.
3. Cash ratio

Current Ratio

The current ratio is a ratio of the firm's total current assets to its total current liabilities. The current ratio is computed by dividing current assets by current Liabilities. Current asset normally includes cash, sundry debtors, inventory, marketable securities, and current liability consists of Sundry creditors, short-term loans and advance current liabilities and provision for taxes and other accrued expenses. The ratio is generally an acceptable measure of short term creditors are covered by assets that are likely to be converted into cash in a period corresponding to the maturity of the claims.

A low ratio is an indicator that a firm may not be able to pay its future bills on time, particularly if conditions change, causing a slowdown in cash collections. A high ratio may indicate an excessive amount of current assets and management's failure to utilize the firm's resources properly.

Current Ratio = Current assets /Current liabilities

Ratio                    2001               2000             1999             1998           1997
Current ratio      .74 Times       .76 Times       .69 Times      .77 Times    .80 Times

BOC Bangladesh Ltd. has formed only in 1975 but still their current asset is lower than current liability. As a result current ratio of this company is very low. We hope they will recover from this situation soon. In this case current ratio has decreased till 1999 from 1997 but in 2000 it has increased because in that year current liability has decreased. But in 2001 current liability has again increased and as a result the current ratio falls.

By going through over the components of current liability in year 2001 we see that short term bank loan and sundry creditors increased at a higher rate compare with year 2000 and other factors are almost same.

Analyzing current asset we see that all of the components has increased over 5 years. But most of the part of this asset is inventory. This inventory is not a pure liquid that’s why it doesn’t give us actual liquidity position of BOC. To get more pure ratio we will discuss about quick ratio.

Quick ratio
The quick ratio, which is also known as acid-test ratio is a better test of financial strength than the current ratio, as it gives no consideration to inventory, which may be very slow moving. Here merchandise inventory is omitted because merchandise is normally sold on credit and then the receivable must be collected before cash is realized. A comparison of the current ratio with quick ratio would give an indication regarding inventory position. Moreover, in the very short-term the ability to meet requirements of cash can be judged only on the basis of a properly drawn cash budget and not on the basis of the quick ratio.

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

Ratio                    2001              2000              1999             1998           1997
Quick ratio      .30 Times       .28 Times       .21 Times      .23 Times    .25 Times

Here we see that current ratio in 2001 is 2.46 time higher than quick ratio because in that year current asset consists more than 59% of inventory. For this reason quick ratio has declined compared to current ratio. The quick ratio is increasing from 1999 because the components of current asset except inventory are increasing at higher arte than that of current liability. By analyzing quick ratio we have realized that the company is reserving more inventories, which can’t make any profit. They must follow just in time process to increase quick ratio and as well as their actual liquidity position.