Question 4: The liquidity of a business firm is measured by its ability to satisfy itslong-
term obligations as they become due. What are the ratios used forthis purpose?
Answer:
Yes it is true that the liquidity of a business firm is measured by its ability to pay its long term obligations as they become due. Here the long term obligation means payments of principal amount on the due date and payments of interests on the regular basis. For measuring the long term solvency of any business we calculate the following ratios.
Debt Equity Ratio: Debt equity ratio indicates the relationship between the
external equities or outsiders funds and the internal equities or shareholders
funds. It is also known as external internal equity ratio. It is determined to ascertain soundness of the long term financial policies of the company. Following formula is used to calculate debt to equity ratio.
Debt Equity Ratio = External Equities.
Shareholders funds
Proprietory Ratio/Total Assets to Debt Ratio: Total assets to Debt Ratio or
Proprietory Ratio are a variant of the debt equity ratio. It is also known as equity
ratio or net worth to total assets ratio. This ratio relates the shareholder’s funds
to total assets. Proprietory / Equity ratio indicates the long-term or future
solvency position of the business. Formula of
Proprietory or Equity Ratio = Shareholders funds
Total Assets
Proprietory/Equity Ratio Interest Coverage Ratio: This ratio deals only with
servicing of return on loan as interest. This ratio depicts the relationship between
amount of profit utilise for paying interest and amount of interest payable. A high
Interest Coverage Ratio implies that the company can easily meet all its interest
obligations out of its profit.
Interest Coverage Ratio = Net Profit before interest and tax
Interest on Long Term loans
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