Monday, 18 February 2013

Applying Sensitivity Analysis on Liquidity Ratios


Sensitivity Analysis on the Liquidity Ratios


In analyzing the ratios, it is important to gauge how sensitive these ratios are to changes in their components. An increase in the numerator of a ratio will increase the value of the ratio, whereas an increase in the denominator of a ratio will reduce the value of the ratio, and vice versa. Since a higher number is preferable for these ratios, a decrease in the numerator or an increase in the denominator adversely affects the ratio and the consequent inferences.
Thus, an increase in liabilities would adversely affect the ratio, whereas an increase in current assets or cash flows (the term in the numerator) would improve the ratios. The amount of increase or decrease in a particular ratio depends on the value of the ratio.
It should be noted that an equal increase in both the numerator and denominator of the ratio would worsen the ratio, if the ratio is greater than 1.
 Similarly, an equal decrease in both the numerator and denominator would improve a ratio that is greater than 1.
Sometimes companies use this mathematical fact to improve the appearance of the liquidity ratios. As an example, paying off current liabilities right before the balance sheet date would improve the current and the quick ratios.
For example. Company Q has current assets of$l,000,000 and current liabilities of $600,000 yielding a current ratio of 1.67.

Current Ratio
= CurrentAssets
Current Liabilities
Current Ratio= $1 ,000,000 / $600,000

= 1.67

If the company were to pay off $200,000 of current liability just prior to preparing its financials, the current assets will reduce to $800,000 and current liability will reduce to $400,000, improving the current ratio to 2.0.
Current Ratio = ($1,OOO00O -  $200,000) / ($600,000 -  $200,000)
= $800,000 / $400,000
=2.0

It is important to note that when companies engage in such activities for the sole purpose of improving the financial ratios, it is called “window dressing” and the behavior may be ethically questionable.

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