LIQUIDITY OF SHORT-TERM ASETS AND LIQUIDITY
RATIO ANALYSIS
Since the short-term debt-paying ability is a very important indicator of the enterprise stability, the liquidity ratio analysis becomes a useful method of analyzing firm’s performance. The ability to pay current obligations means there is a higher chance company can also maintain a long-term debt-paying ability and not find itself bankrupt because of not being able to meet its obligations to short-term creditors. Having systematic troubles meeting its short-term obligations means a higher risk of firm’s bankruptcy, thus calculating the liquidity ratios and analyzing the results is highly important both for company owners and for potential investors.
Liquidity Ratio Calculation and Analysis
The formula for the current ratio is as follows:
Current Ratio = Current Assets ÷ Current Liabilities
The current ratio indicates a firm's ability to pay its current liabilities from its current assets. This is the basic indicator of the company’s liquidity. Higher numbers are better, meaning that the current assets amount of a firm is higher comparing to current liabilities and thus company has the ability to easily pay off its short-term debt. Generally the normal value for this ratio is 2 or more. However, the comparison with other similar companies should necessarily be made, because for some industries values below 2 are adequate.
Chart 4. Financial data
The data shows that the company is able to meet its current obligations. For every dollar of current liabilities there is a dollar of current assets.
Quick Ratio (Acid Test Ratio)
The purpose of calculating the quick ratio (also referred as acid test ratio) is to measure how well a company can meet its short-term obligations with its most liquid assets:
Quick Ratio = (Cash Equivalents + Marketable Securities + Net Receivables) ÷ Current Liabilities
This formula can be used for the most conservative ratio calculation, when one needs to exclude items that don’t represent current cash flow from current assets. The normal value for this ratio is 1, but as with current ratio, the comparison with similar companies should be made, because in some industries firms with the quick ratio below 1 still have normal liquidity.
A common alternative formula for acid test ratio is:
Quick Ratio = (Cash + Marketable Securities + Accounts and Notes Receivable) ÷ Current Liabilities
This formula provides you with an indication of the business liquidity by comparing the amount of cash, marketable securities and accounts and notes receivable to current liabilities. Should also be mentioned, that the quick ratio does not include inventory and prepaid expenses in the calculation, which is the main difference between the current ratio and the quick ratio.
Finally, another formula for calculating quick ratio exists, which is more general:
Quick Ratio = (Current assets - Inventory) ÷ Current Liabilities
The quick ratio allows to focus on quick assets (those that could be quickly converted to cash), that’s why it keeps inventories out of equation. Once again, the normal value for this ratio is 1 or more, meaning that for every dollar of company’s current liabilities the firm has at least 1 dollar of very liquid assets to cover those immediately, if needed.
Cash Ratio
A way of company’s cash and equivalents amount estimation in terms of liquidity is the calculation of the cash ratio. That can be done using the following formula:
Cash Ratio = (Cash Equivalents + Marketable Securities) ÷ Current Liabilities
The cash ratio is the most conservative indicator of firm’s liquidity, indicating its immediate liquidity. Having calculated the cash ratio one can see how well a company can pay off its current liabilities with only cash and cash equivalents. However, it is not realistic to expect the company to have enough cash and equivalents to cover all the current liabilities, because if this occurs, it means that the company’s usage of cash is not efficient as cash should rather be put to work in the operations of the firm. Considering this, the detailed knowledge of the business is required to have a chance to draw a conclusion based on the cash ratio calculation. Most commonly, big values of cash ratio would mean inappropriate usage of cash by the company, while cash ratio lesser than 0.2 would mean that the firm might face an immediate problem with paying bills.
Company’s working capital indicates its short-run solvency and financial sustainability. The calculation formula for the working capital as follows:
Working Capital = Current Assets - Current Liabilities
The working capital amount is a value that should be compared with past periods of time within the same company to determine its reasonability, while comparing the working capital amount of different companies is pointless due to the different sizes of firms. Current assets are assets that are expected to be turned into cash by a company within one year, or one business cycle. Analogically, current liabilities are liabilities that are expected to be paid by a firm within a year, or one business cycle. Financially sustainable business would be able to pay its current liabilities with its current assets.
Sales to Working Capital (Working Capital Turnover)
A part of liquidity ratio analysis is the calculation of sales to working capital (also referred as working capital turnover). The formula for doing that is as follows:
Sales to Working Capital = Sales ÷ Average Working Capital
The sales to working capital ratio indicates how much cash is needed to generate a certain level of sales. In other words, it measures dollars of sales generated by a dollar of working capital investment. That’s why a low working capital turnover ratio most likely indicates that the use of the working capital is unprofitable. This means that sales are not adequate in relation to the working capital. As with many other ratios, before drawing a conclusion based on sales to working capital ratio, one should make a comparison with other similar companies, industry averages, to compare the dynamics of this ratio comparing to the past periods. Seeing the increase of sales to working capital in dynamics over some period would witness the overall increase of liquidity of the firm.