Ratio analysis II: liquidity, gearing and investor ratios
Liquidity ratios test short-term debt-paying ability; gearing shows reliance on borrowed funds; investor ratios such as EPS and P/E show returns per share.
Liquidity, gearing and investor formulas
| Ratio | Formula | What it tells you |
|---|---|---|
| Current ratio | Current assets ÷ current liabilities | Ability to pay short-term debts |
| Quick (acid test) ratio | (Current assets − inventory) ÷ current liabilities | Liquidity without relying on selling inventory |
| Gearing | Long-term debt ÷ (long-term debt + equity) × 100 | Share of long-term funds that is borrowed |
| Debt to equity | Long-term debt ÷ equity × 100 | Borrowing compared with owners' funds |
| Interest cover | PBIT ÷ interest | How many times profit covers interest |
| Earnings per share (EPS) | (Profit for the year − preference dividend) ÷ number of ordinary shares | Profit earned for each ordinary share |
| Price/earnings (P/E) ratio | Market price per share ÷ EPS | How many years of earnings investors pay for |
| Dividend per share (DPS) | Ordinary dividends for the year ÷ number of ordinary shares | Cash return per share |
| Dividend cover | EPS ÷ DPS | How safely profit covers the dividend |
| Dividend yield | DPS ÷ market price × 100 | Cash return on the share price |
Worked example 1: liquidity and gearing of Serendib Foods PLC
From the 2026 statements (Rs. '000): current assets 33,000, of which inventory 13,000; current liabilities 15,000; 12% debentures 25,000; total equity 83,500, of which preference shares 10,000; operating profit (PBIT) 26,000; finance costs 3,000.
- Current ratio: 33,000 ÷ 15,000 = 2.2 : 1.
- Quick ratio: (33,000 − 13,000) ÷ 15,000 = 20,000 ÷ 15,000 = 1.33 : 1.
- Gearing: 25,000 ÷ (25,000 + 83,500) × 100 = 25,000 ÷ 108,500 × 100 = 23.0%.
- Debt to equity: 25,000 ÷ 83,500 × 100 = 29.9%.
- Interest cover: 26,000 ÷ 3,000 = 8.7 times.
- If preference shares are treated as prior-charge capital: (25,000 + 10,000) ÷ 108,500 × 100 = 32.3%.
Current ratio 2.2 : 1, quick ratio 1.33 : 1, gearing 23.0% (32.3% if preference shares count as debt), interest cover 8.7 times: a liquid, low-geared company.
Worked example 2: investor ratios
Serendib Foods: profit for the year Rs. 18,500,000; preference dividend Rs. 1,000,000; 4,000,000 ordinary shares; ordinary dividends for the year Rs. 1.50 interim + Rs. 2.00 final per share; market price Rs. 52.50 per share.
- EPS: (18,500,000 − 1,000,000) ÷ 4,000,000 = 17,500,000 ÷ 4,000,000 = Rs. 4.375, about Rs. 4.38.
- DPS: 1.50 + 2.00 = Rs. 3.50.
- Dividend cover: 4.375 ÷ 3.50 = 1.25 times.
- P/E ratio: 52.50 ÷ 4.375 = 12 times.
- Dividend yield: 3.50 ÷ 52.50 × 100 = 6.7%.
- Payout ratio: 3.50 ÷ 4.375 × 100 = 80%.
EPS Rs. 4.38, DPS Rs. 3.50, dividend cover 1.25 times, P/E 12, dividend yield 6.7%. Paying out 80% of earnings leaves little profit for growth.
Reading the liquidity ratios
A traditional rule of thumb is a current ratio of about 2 : 1 and a quick ratio of about 1 : 1, but the right level depends on the industry. Supermarkets that sell for cash and turn inventory quickly can work safely with much lower ratios, while a manufacturer with slow-moving stock needs more. A ratio that is too high can also be a warning: cash, inventory or receivables may be lying idle instead of earning a return.
High gearing: good or bad?
Compare gearing with similar companies: businesses with heavy fixed assets, such as power and telecom companies, often carry more debt than retailers.
Limitations of ratio analysis
- Ratios use past, year-end figures that may not represent the whole year.
- Different accounting policies (inventory, depreciation) make comparisons unfair.
- Inflation distorts comparisons over time.
- Window dressing near the year end can flatter liquidity.
- Ratios show symptoms, not causes; read them with non-financial information.
- Horizontal (trend) analysis and vertical (common-size) analysis help put ratios in context.
Investors on the Colombo Stock Exchange compare EPS, P/E and dividend yield before buying shares, and banks check gearing and interest cover before lending more. Listed companies' published annual reports give all the figures needed.
Short answer: “What does the quick ratio measure?” The ability to pay current liabilities from current assets other than inventory: (current assets − inventory) ÷ current liabilities.
Structured question: “Calculate EPS, the P/E ratio, dividend cover and dividend yield from the given data.” EPS after preference dividends, then P/E = price ÷ EPS, cover = EPS ÷ DPS, yield = DPS ÷ price × 100, with a one-line comment on each.
Essay: “Calculate and comment on the liquidity, gearing and investor ratios of a company, and state the limitations of ratio analysis.” Ratios with workings, comments on liquidity, financial risk and investor returns, then four or five limitations.
Liquidity: current and quick. Gearing: debt ÷ (debt + equity). Investors: EPS → P/E; DPS → cover and yield. Always deduct preference dividends before calculating EPS.