Ratio Analysis (Liquidity Ratios)

Ratio Analysis (Liquidity Ratios)

Liquidity Ratios

Liquidity ratios assess the correlation between a company’s cash and other current assets in relation to its current liabilities. The liquidity of current assets is influenced by their nature (cash, receivables, inventory, etc.), while the liquidity of current liabilities is influenced by factors such as the firm’s creditworthiness, reputation, size, and capital levels. Larger, creditworthy organizations with substantial capital can typically secure short-term credit for more extended periods and at lower or zero interest rates.

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A. Current Ratio

1. Computed by dividing current assets by current liabilities.
2. Reflects the degree to which current liabilities are covered by assets anticipated to be converted into cash in the near term.
3. Widely used as a measure of short-term solvency.
4. A low current ratio may signal potential solvency issues, while an exceptionally high ratio may indicate ineffective current asset management (e.g., excess cash, accounts receivable, or inventory).

Current Ratio =Current Assets /Current Liabilities

B. Quick (Acid Test) Ratio

B. Quick (Acid Test) Ratio

1. Calculated by subtracting inventories and prepayments from current assets and dividing the remaining figure by current liabilities.
2. Assesses the ability to settle short-term obligations without relying on inventory sales.
3. An increasing quick ratio suggests improved capability to meet short-term financing needs, and vice versa.
4. Considered a superior indicator of a company’s short-term obligation meetability compared to the current ratio, as it excludes inventory. Inventory liquidation might take time, making it less readily available for short-term obligations.
5. For instance, a library or retail store might maintain high inventory levels, potentially distorting the current ratio due to the inventory’s limited convertibility into cash without compromising sales value.

Quick Ratio =(Current Assets – Inventories – Prepayments) / Current Liabilities
Or

Quick Ratio =(Cash + Marketable Securities + Receivables ) / Current Liabilities

C. Cash Ratio

1. Determined by dividing cash and marketable securities by current liabilities.
2. Assesses a company’s ability to settle current liabilities without relying on liquidating inventory and accounts receivable.

Cash Ratio =(Cash + Marketable Securities) / Current Liabilities

D. Cash Flow Ratio

1. Obtained by dividing operating cash flow by average current liabilities.
2. Measures a company’s capacity to meet current debt obligations using cash generated from normal operations.

Cash Flow Ratio =Cash flow from operations /Average Current Liabilities

E. Working Capital (Net Working Capital)

1. The terms “Working Capital” and “Net Working Capital” are generally interchangeable.
2. Calculated by deducting current liabilities from current assets.
3. Represents a company’s absolute liquidity—remaining working capital after settling all outstanding current liabilities.

Net Working Capital = Current Assets – Current Liabilities

Net working capital ratio is calculated by dividing the net working capital by the total assets.

Net Working Capital Ratio =Net Working Capital /Total Assets