Page 140 - DMGT310_ENTREPRENEURSHIP_AND_SMALL_BUSINESS_MANAGEMENT

Unit 9: Financial Considerations

period of time. Since the venture has no historical balance sheet or past performances, these are Notes
evaluated on the basis of the projected balance sheet and other forecasted documents. These
allow comparison of the projected performance with similar industries or similar businesses.
Financial ratios fall into four general categories. These can be classified as:

Liquidity Ratios

Liquidity ratios are indicators of the venture’s capability to meet short-term financial obligations.
Short term obligations imply cash demand to be met in next 12 months. Maximum use of this
ratio is made by the providers of the short term credit to the ventures. Three of the most
common liquidity ratios are (a) current ratio or working capital ratio, (b) quick ratio or acid test
ratio, and, (c) cash ratio.
The current ratio is the ratio of current assets to current liabilities:

Current Assets
Current Ratio =
Current Liabilities
Providers of short-term creditors prefer high current ratio as it reduces their risk of non-payment.
It signifies venture liquidity. Contrarily, shareholders are known to prefer low current ratio as
it implies liquidity deployment to create more wealth. Values for the current ratio vary from
industry to industry and venture to venture in same industry. Ventures exposed to cyclical
upswing and downturns maintain high incidence of current ratio to remain liquid during
downturns. A current ratio of 1 or more than 1 is considered acceptable for most of the industries.
Any opinion should not be formed exclusively on the basis of the current ratio of the venture.
Many other factors need to be considered before any conclusion can be drawn. A high current
ratio of more than 2, indicates excessive current assets in the form of inventory and under
deployed financial resources. A low ratio of less than 1, indicates that venture may have difficulty
in meeting short-term financial obligations.
The quick or the acid test ratio is the ratio of current assets — inventory to current liabilities:

The component of inventory in current ratio may consist of certain inputs or raw materials that
may not be possible to be liquidated at short notice. The liquidation value may also be uncertain.
The quick ratio is a refinement on the current ratio as it excludes inventory from the current
assets of the venture. Such exclusion, removes the ambiguity created in the liquidity position of
the venture by uncertain inventory components.
CurrentAssets –Inventory
Quick Ratio =
Current Liabilities
The current assets that are used to calculate quick ratio (acid test ratio) include cash, accounts
receivable and notes receivable.
Cash ratio is one of the most conservative of all liquidity ratios. It is an extreme refinement on
quick ratio. It excludes all current assets of the venture except the absolutely liquid assets
available. These consist of cash in hand or bank and other cash equivalents.

Cash Ratio

The cash ratio is ratio of cash + cash equivalent securities to current liabilities of the venture.
It is the most robust indicator of venture ability to meet current liabilities. Higher cash ratio
could be a cause of concern as it represents the situation in which the resources may not be
optimally deployed for creation of wealth.

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