Financial Ratio on Assessing The Liquidity Of A Company
Continued from my last article, we now look at the financial ratio for assessing the liquidity of a company.
Here, liquidity means the firm’s ability to satisfy its short-term obligations as they come due.
Two typical ratios are recommended:
· The Current Ratio, and
· The Quick (Acid-Test) Ratio.
Tabulated as follows for easy reference:
Ratio
QUICK RATIO or ACID TEST RATIO
Formula
Total Current Assets minus Inventory
Total Current Liabilities
Use
Measure the ability to pay urgent liabilities, a MORE stringent test to meet short term obligations. Focus on only the most liquid of the firm’s current assets : cash, marketable securities and accounts receivable
Values
>1:1 is good as it indicates that if sales revenue disappeared, the business could meet its current obligations with readily available “quick” funds on hand.
1:1 is satisfactory unless the majority of “quick” assets are in accounts receivable & company has a pattern of collecting accounts receivable slower than paying accounts payable
Interpretation
No of times Liquid Current assets is over Current Liabilities
Industry implications
Linked to cash flow cycle
Trend is important
Better working capital management makes ratio fall
Seasonal factors are relevant
Too high indicates poor working capital management
Higher quick ratios are needed when a company has difficulty borrowing on short term notice
Ratio
QUICK RATIO or ACID TEST RATIO
Formula
Total Current Assets minus Inventory
Total Current Liabilities
Use
Measure the ability to pay urgent liabilities, a MORE stringent test to meet short term obligations. Focus on only the most liquid of the firm’s current assets : cash, marketable securities and accounts receivable
Values
>1:1 is good as it indicates that if sales revenue disappeared, the business could meet its current obligations with readily available “quick” funds on hand.
1:1 is satisfactory unless the majority of “quick” assets are in accounts receivable & company has a pattern of collecting accounts receivable slower than paying accounts payable
Interpretation
No of times Liquid Current assets is over Current Liabilities
Industry implications
Linked to cash flow cycle
Trend is important
Better working capital management makes ratio fall
Seasonal factors are relevant
Too high indicates poor working capital management
Higher quick ratios are needed when a company has difficulty borrowing on short term notice
April 5, 2006
Posted in: Ratio Analysis
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