Question

Match the items of List I with those of List II and choose the correct code of combination

List I		List II
a.	Inability to pay interest	i)	Current ratio
b.	Liquidity crisis	ii)	Debtor turnover ratio
c.	Inefficient collection of receivable	iii)	Interest coverage ratio
d.	Return of shareholder’s fund being much higher than the overall return on investment	iv)	Debts – Equity ratio

1. a-iii, b-i, c-ii, d-iv
2. a-iii, b-ii, c-i, d-iv
3. a-ii, b-iii, c-i, d-iv
4. a-i, b-ii, c-iii, d-iv

Answer 1

Correct Answer - Option 1 : a-iii, b-i, c-ii, d-iv

The explanation of the above ratio:

1. Current Ratio:

• The current ratio compares all of a company’s current assets to its current liabilities. These are usually defined as assets that are cash or will be turned into cash in a year or less, and liabilities that will be paid in a year or less.
• The current ratio is sometimes referred to as the “working capital” ratio and helps investors understand more about a company’s ability to cover its short-term debt with its current assets.
• Weaknesses of the current ratio include the difficulty of comparing the measure across industry groups, overgeneralization of the specific asset and liability balances, and the lack of trending information.
• Current Ratio= Current Assets/Current Liabilities

2. Debtor turnover ratio :

• While calculating this ratio, only the net credit sales is to be taken into consideration.
• Ideally, a company compares its debtors turnover ratio with the companies that have similar business operations and revenue and lie within the same industry.
• The formula to compute Debtors Turnover Ratio is: Debtors Turnover Ratio = Net Credit Sales/Average Account Receivable.
  • Where Average Account Receivable includes trade debtors and bill receivables.
  • The higher the Debtors turnover ratio, the better is the credit management of the firm.

3. Interest coverage ratio:

• The interest coverage ratio is used to see how well a firm can pay the interest on outstanding debt.
• Also called the times-interest-earned ratio, this ratio is used by creditors and prospective lenders to assess the risk of lending capital to a firm.
• A higher coverage ratio is better, although the ideal ratio may vary by industry.
• The Formula for the Interest Coverage Ratio: Interest Coverage Ratio=Interest Expense/EBIT​
  • Where, EBIT=Earnings before interest and taxes​

4. Debt Equity Ratio

• The debt-to-equity (D/E) ratio compares a company’s total liabilities to its shareholder equity and can be used to evaluate how much leverage a company is using.
• Higher leverage ratios tend to indicate a company or stock with higher risk to shareholders.
• However, the D/E ratio is difficult to compare across industry groups where ideal amounts of debt will vary.
• Investors will often modify the D/E ratio to focus on long-term debt only because the risk of long-term liabilities are different than for short-term debt and payables.
• Debt Equity Ratio= Total Liabilities/Total shareholder’s Equity

Therefore, the correct match is:

List I		List II
a.	Inability to pay interest	i)	Interest coverage ratio
b.	Liquidity crisis	ii)	Current ratio
c.	Inefficient collection of receivable	iii)	Debtor turnover ratio
d.	Return of shareholder’s fund being much higher than the overall return on investment	iv)	Debts – Equity ratio

Hence Option 1 is correct.