One of the most basic sets of ratios for consideration is the Liquidity Ratios. These ratios are useful in demonstrating the company’s ability to meet its maturing financial obligations as and when due. The focus is on short-term solvency as if the firm were liquidated today at book value. It is essential for a company to have sufficient short term assets to cover its current liabilities, through the generation of adequate cash to cover the various costs.
Liquidity ratios, highlight the cash levels of a company and its ability to turn other assets into cash to pay off liabilities and other current obligations. Assets considered are cash and cash equivalents, accounts receivable, marketable securities, and inventory, as they are relatively easy for companies to convert into cash in the short term. Thus, all of these assets go into the liquidity calculation of a company.
A measure of a company’s ability to pay off the short-term liabilities with its current assets is termed as the Current Ratio. Companies with higher current assets can pay off their current liabilities with ease, when due without any need to sell long-term revenue generating assets. Also, referred to as a Working Capital Ratio, it includes all the for the purpose of calculation.
Current Ratio or Working Capital Ratio is calculated as:
CuR (WCR) = Current Assets / Current Liabilities
Current assets considered are cash, marketable securities, inventory, accounts receivable, and current liabilities considered are debt and accounts payable.
A higher current ratio implies that the company would have no issues in paying off its short term debts.
A current ratio of 1 indicates that the firm would have to sell all of its current assets in order to pay off its current liabilities. While a ratio of greater than 1 is termed as positive working capital and is considered preferable, a ratio of less than 1 is considered risky by the lenders and termed as negative working capital. It is not definitive in assuming that negative working capital is bad, as companies which can turn around their inventory faster have negative working capital, meaning, they use the customers advances efficiently in meeting the short term debt obligations.
Higher current assets or lower current liabilities help in increasing the working capital ratio and lower current assets or higher current liabilities result in decreasing the working capital ratio.
Similar to the current ratio, the Quick Ratio measures the ability of a business to pay its short-term liabilities by having assets that are readily convertible into cash. But unlike the current ratio, the liquid assets include only cash, marketable securities and accounts receivable. Though inventory (along with prepayments) is considered as a part of the current assets, since it cannot be liquidated to quickly converted into cash, it is not considered for the calculation.
The quick ratio is also referred to as the Acid Test Ratio, as it defines a company’s ability to quickly raise cash from liquid assets to pay its short term liabilities.
Quick Ratio / Acid Test Ratio / Liquid Ratio is calculated as:
QR = (Cash + Marketable Securities + Receivables) / Current Liabilities
The quick ratio is more conservative than the current ratio as it considers only genuine liquid assets. A company with a high and/or increasing quick ratio is probably experiencing good revenue growth, collecting its accounts receivable and turning them into cash quickly.
As the name suggests, Cash Ratio measures the company’s ability to pay its current liabilities using only cash and marketable securities. The elimination of accounts receivable used in the earlier liquidity ratios provides us with a ratio that indicates the firm’s cash position and near-cash investments relative to their current liabilities. Marketable securities are short-term instruments that are as good as cash and near cash investments.
Cash Ratio is calculated as:
CaR = (Cash + Marketable Securities + Receivables) / Current Liabilities
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