Question

outline two ratios that can be used to identify resources required by an organisation to meet short-term and long-term obligations

Answer 1

Q) Two ratios that can be used to identify resources required by an organisation to meet short-term obligations.

Introduction:

The firm’s ability to meet its short-term obligations is calculated by using Liquidity Ratios. In simple words we can say that Liquidity Ratio shows the firms ability to meet its short-term obligations without raising external capital.

Common Liquidity Ratio that can be used to identify resources required by an organisation to meet short-term obligations are:

a) Current Ratio (Sometime called working capital ratio):

It shows the firms ability to pay its current liabilities out of its current assets i.e. cash, bills receivables.

It is calculated by using the following formula:

Current Ratio = Current Assets / Current Liabilities

The ideal current ratio is 2:1 i.e. ideally the current assets should be double the current liability.

b) Quick Ratio (Sometimes called acid test ratio) :

It shows the firm’s ability to pay its current liabilities out of its liquid assets i.e. current assets less inventories and prepaid expenses (as these are considered to be less liquid).

It is calculated by using the following formula:

Quick Ratio = (Current Assets – Inventories – Prepaid expenses) / Current Liabilities

The ideal quick ratio is 1:1 i.e. ideally the liquid assets should be equal to the current liability.

Two ratios that can be used to identify resources required by an organisation to meet long-term obligations.

Introduction:

The firm’s ability to meet its long-term obligations is calculated by using Solvency Ratio. In simple words we can say that Solvency Ratio financial health of a company and the sustainability of the company in the long run.

Common Solvency Ratio that can be used to identify resources required by an organisation to meet Long-term obligations are:

a) Debt- Equity Ratio (Sometimes called as Balance Sheet ratio):

This ratio shows the amount of total debt in comparison to equity. This is calculated by dividing the business’s total liabilities shareholders’ equity.

It is calculated by using the following formula:

Debt- Equity Ratio = Total Liability (Long term + short term) / shareholder’s equity

The maximum Debt Equity ratio should be 2:1.

b) Interest coverage ratio:

Generally, all the debts carry interest cost. This ratio shows that whether the firm is able to pay the interest on its long-term debt by its net profit before interest and tax.

It is calculated by using the following formula:

Interest coverage ratio: Net profit before interest and tax / Interest on Long term debt

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