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Assessing A Company’s Liquidity

Let’s look at the financial ratio for assessing the liquidity of a company. 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
  1. No of times Liquid Current assets is over Current Liabilities
  2. Industry implications
  3. Linked to cash flow cycle
  4. Trend is important
  5. Better working capital management makes ratio fall
  6. Seasonal factors are relevant
  7. Too high indicates poor working capital management
  8. 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
    1. No of times Liquid Current assets is over Current Liabilities
    2. Industry implications
    3. Linked to cash flow cycle
    4. Trend is important
    5. Better working capital management makes ratio fall
    6. Seasonal factors are relevant
    7. Too high indicates poor working capital management
    8. Higher quick ratios are needed when a company has difficulty borrowing on short term notice

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