The measurement of a firm's short run ability to pay its debts as they come due is a very important aspect of financial analysis. Most credit analysts use the current and quick ratios for this purpose.
Many businesses find it necessary at some point to borrow funds. Lenders need to assess the credit worthiness of borrowers. Two determinants of credit worthiness are the existence and extent of collateral and the liquidity of the business.
The balance sheet can be useful in assessing both factors. Collateral are those assets that are pledged by a lender to secure a loan. Even though assets, particularly fixed assets, are not reported at current fair market values on the balance sheet, the lender can determine the kind of assets the business owns and the extent of debt to other lenders. It is usually not difficult for lenders to reach reasonable estimates of the current liquidating values of most business assets, so their absence on the balance sheet usually is not a major problem.
Liquidity is another useful determinant of credit worthiness. Liquidity refers to the availability of cash to the business. Obviously, lenders are concerned whether borrowers will have sufficient cash to repay loans. Liquidity is mainly a function of profitability. Ordinarily, the more profitable the business, the more cash available. However, liquidity is not simply a function of profitability, and firms of comparable profitability do not necessarily have comparable liquidity.
Liquidity ratio, expresses a company's ability to repay short-term creditors out of its total cash. The liquidity ratio is the result of dividing the total cash by short-term borrowings.
It shows the number of times short-term liabilities are covered by cash. If the value is greater than 1.00, it means fully covered.
Short Term Accounting Liquidity Ratios
1) Working Capital
Working capital is a measure of a firm's ability to pay off short term debt and have enough money to finance its day to day business operations.
The formula for Working Capital is:
Working Capital = Current Assets - Current Liabilities
Therefore, if Current Assets are greater than Current Liabilities, than the firm is financially healthy in the short term.
However, if Current Liabilities are greater than Current Assets, the company may have to borrow additional debt (bond financing) to finance its day to day business operations, and if conditions do not change, it may be heading towards bankruptcy.
A low ratio of Current Assets could indicate that the company is having a hard time getting Cash Sales and thus focusing its business on Accounts Receivable Sales. It also indicates that the company is having a hard time collecting these accounts receivable sales (customers are not paying on time, or not paying at all).
If Working Capital is low, this can also indicate the company's business operations are not very efficient. The cycle of making a sale, collecting the cash and paying down current expenses is not at optimum level and needs to be improved.
2) Current Ratio
The current ratio is a measure of a firm's short term liquidity. The formula is:
Current Ratio = Current Assets / Current Liabilities
Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may prefer a lower current ratio so that more of the firm's assets are working to grow the business. Typical values for the current ratio vary by firm and industry.
For example, firms in cyclical industries may maintain a higher current ratio in order to remain solvent during downturns. The general rule of thumb is the higher the current ratio, the better. Most investors prefer a Current Ratio of 2:1 meaning $2 of Current Assets for every $1 of Current Liabilities.
3) Quick or Acid-Test Ratio
The quick ratio is a tougher test of liquidity than the current ratio. It eliminates certain current assets such as inventory and prepaid expenses that may be more difficult to convert to cash. Like the current ratio, having a quick ratio above one means a company should have little problem with liquidity.
The higher the ratio, the more liquid it is, and the better able the company will be to ride out any downturn in its business.
Thus, the formula for Acid-Test Ratio is:
Acid-Test Ratio = (Current Assets - Inventory - Prepaid Assets) / Current Liabilities
The current assets used in the quick ratio are cash, accounts receivable, and notes receivable. These assets essentially are current assets less inventory. The quick ratio often is referred to as the acid test.
4) Cash Ratio
The cash ratio is the most conservative liquidity ratio of all. It only measures the ability of a firm's cash, along with investments that are easily converted into cash, to pay its short-term obligations. Along with the quick ratio, a higher cash ratio generally means the company is in better financial shape.
Cash Ratio = (Cash + Short-Term or Marketable Securities) / (Current Liabilities)
5) Absolute Liquidity Ratio
Cash + Marketable Securities/ Current Liabilities = Absolute Liquidity Ratio
A subsequent innovation in ratio analysis, the Absolute Liquidity Ratio eliminates any unknowns surrounding receivables.
Note: The Absolute Liquidity Ratio only tests short-term liquidity in terms of cash and marketable securities.
6) Basic Defense Interval
(Cash + Receivables + Marketable Securities)/(Operating Expenses + Interest + Income Taxes) / 365 = Basic Defense Interval
If for some reason all of your revenues were to suddenly cease, the Basic Defense Interval would help determine the number of days your company can cover its cash expenses without the aid of additional financing.
7) Average Collection Period Ratio
(Accounts + Notes Receivable)/(Annual Net Credit Sales) / 365 = Average Collection Period Ratio
The Average Collection Period (ACP) is another litmus test for the quality of your receivables business, giving you the average length of the collection period. As a rule, outstanding receivables should not exceed credit terms by 10-15 days. If you allow various types of credit transactions, such as a retail outlet selling both on open credit and installment, then the ACP must be calculated separately for each category.
Note: Discounted notes which create contingent liabilities must be added back into receivables.
8) Inventory Turnover Ratio
Cost of Goods Sold/Average Inventory = Inventory Turnover Ratio
Rule of Thumb: Multiply your inventory turnover by your gross margin percentage. If the result is 100 percent or greater, your average inventory is not too high.
9)Accounts Receivable Turnover Ratio
Another important set of liquidity ratios for a business with significant credit sales is the accounts receivable turnover and average collection period ratios.
Accounts Receivable Turnover Ratio = Credit Sales/Average Accounts Receivable
Credit sales are all non-cash sales. Average accounts receivable is the average of the beginning and end of period balances. The higher the turnover, the quicker the collections.