A ratio which defines the efficiency and liquidity of a firm and it measures a company’s capacity to meet its liabilities of short-term side by its current assets. The current ratio is a primary type of liquidity because liabilities of short-term are payable within the following year. Current Ratio is also called Working capital ratio.
This suggests that a firm has a prescribed amount of time to increase funds to return for these liabilities. Current assets such as financial securities and cash and cash equivalents can quickly be transformed into cash within the year. This indicates that firms with larger numbers of current assets will numerous comfortably be able to meet its current liabilities when they mature outstanding without possessing to repay long-term, income-generating assets.
The formula of Working Capital or Current Ratio:
The simplest form to calculate the working capital or current ratio is dividing CA (Current Assets) by CL (Current Liabilities). We are going to share the formation below:
Working Capital or Current Ratio
Generally Accepted Accounting Principle (GAAP) needs that firms divide short and long-term assets and as well as the liabilities on the balance sheet. This separation enables investors and lenders to calculate fixed ratios such as the working capital or current ratio.
Analysis of Working Capital or Current Ratio:
The current ratio or working capital encourages investors and lenders recognize the liquidity of a firm and how quickly that firm will be prepared to meet its current liabilities. This ratio displays a company’s current debt regarding current assets. So when a company has a working capital or current ratio of 4 that indicates that the firm has four times current assets than the current liabilities.
When a company has a high current ratio or working capital, it has considered as a better scenario because it shows that the company can easily and quickly pay its payments of debts.
When the company sold its fixed assets just to pay off its CL (Current Liabilities), it has considered as the firm is not able to make enough revenue from its operations to support its ongoing activities. In simple words, the company is in the loss, is not making the profit. Accounts receivables can be the result of those poor collections.
An Example of Working Capital or Current Ratio:
Kevin’s Ice Cream Shop sells ice-cream to local society. Kevin is applying for loans to build the fund and make his dream come true of having a great Ice-Cream Parlor. Kevin’s bank asks for his balance sheet. So, that, they can examine his current scenarios of debt levels. Kevin’s balance sheet has Current liabilities of $100,000, and he only has Current assets of $25,000. Kevin’s working capital or current ratio would be computed like this:
Times Interest Earned Ratio:
The Coverage Ratio or it has a different name called times interest earned ratio, which used to estimate the proportionate value of revenue that can be applied to protect interest charges.
In other regards, TIER has examined a solvency ratio as it includes a firm’s capacity to build interest and mortgage adjustments. Since certain interest returns are given on a long-run support, they have usually used as a continuous, fixed cost. As with maximum fixed expenditures, if the organization can’t execute the adjustments, the firm could run insolvent and discontinue existing. Therefore, this it is important to calculate a solvency ratio.
The formula of Times Interest Earned Ratio:
This ratio can be estimated by dividing EBIT by Interest Expenses:
Both appearances can be located on the Profit and loss statement. Interest cost and taxes have usually listed individually from the ordinary working expenditure for solvency summary persistence. This also creates it obvious to calculate the EBIT.
The TIER has affirmed in quantities as reversed to a %. The proportion shows how multiple times a corporation could return the interest with its before-tax returns, so indeed, the higher ratios have analyzed more desirable than smaller ratios.
In other terms, a ratio of four suggests that a firm makes sufficient revenue to pay for its cumulative interest expense four times higher. Said different way, this company’s revenue is four times greater than its interest cost for the year.
As you can recognize, lenders would favor a firm with a much greater times interest ratio because it gives the firm can manage to pay its interest adjustments when they come outstanding. Larger ratios are light risky although lower ratios symbolize credit risk.
An example of Interest Expense:
Tom’s builder is a contractor and construction firm, who wants to apply for a new load to buy new types of equipment for the business. When Tom applies for a new loan, before considering the load, banks ask for his company’s financial statements. Tom’s financial statements reflect that his firm made nearly about the income of $500,000 before interest and taxed. Overall interest expenses of Tom’s firm were near $50,000. Let’s calculate the Times interest earned ratio of Tom’s firm:
As it displays, it has a ratio of ten. This indicates that Tom’s business revenue is ten times higher than his annual interest expenses. In different words, Tom’s firm can easily afford to pay its additional interest expenses. Overall scenario of Tom’s business shows that Tom’s firm is less risky and the bank can easily give him a loan to buy new equipment for his business or industry.