Liquidity Ratios - BC Bookkeeping Tutorials|dwmbeancounter.com

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Liquidity Ratios

Ratios
Liquidity Ratios
Liquidity ratios measure a company's ability to pay short term debt obligations (debts due less than a year). In general, a higher liquidity ratio shows a company is more liquid and has a better ability to pay it's outstanding debts. These ratios are normally calculated when financial statements are prepared - monthly, quarterly, and annually.
Cash Ratio
  • What It Tells Us: Cash Rato measures a company‚Äôs ability to pay off short-term liabilities with cash. It's the most stringent of the liquidity ratios.
  • Calculation: Cash divided by Current Liabilities
  • Formula: Cash Ratio = Cash / Current Liabilities
  • How Normally Expressed: Ratio
  • Bad or Good: As a rule of thumb, a cash ratio equal to or greater than 1:1 (1.0) is considered good. A ratio of less than .5:1 (.5) could indicate potential cash flow problems. The greater the ratio, the smaller the risk to creditors. You should use your financial information to spot trends and compare to industry averages if available.
  • Additional Clarification: A ratio of 1:1 (1.0 ) means that you have $1.00 of cash for every $1.00 of current liabilities. A ratio of .5:1 (.5 ) means that you have $.50 of cash for every $1.00 of current liabilities.
Example:
Cash Ratio
Information: Dollars in thousandsMonthQuarter Year
Cash For Period212934
Current Liabilities For Period323336
Cash Ratio.66:1.88:1.94:1
Cash / Current Liabilities
Our example ratios mean that for the month we had 66 cents, for the quarter we had 88 cents, and for the year we had 94 cents of cash for every $1.00 of current liabilities.
Quick Ratio (Acid Test)
  • What It Tells Us: Quick Ratio measures a company's ability to pay off short-tem liabilities using liquid assets. The acid-test ratio disregards current assets that are difficult to liquidate quickly such as inventory.
  • Calculation: (Cash plus Short Term Investments plus Accounts Receivable) divided by Current Liabilities
  • Formula: Quick Ratio =  (Cash + Short Term Investments + Accounts Receivable) / Current Liabilities
  • How Normally Expressed: Ratio
  • Bad or Good: As a rule of thumb, a quick ratio equal to or greater than 1.5:1 (1.5) is considered good; less could indicate potential problems in paying creditors. The greater the ratio, the smaller the risk to creditors. You should use your financial information to spot trends and compare to industry averages if available.
  • Additional Clarification: A ratio of 1.5:1 (1.0)  means that you have $1.50 of liquid assets for every $1.00 of current liabilities. The greater the ratio, the smaller the risk to creditors.
Example:
Quick Ratio
Information: Dollars in thousandsMonthQuarter Year
Cash For Period212934
Marketable Securities For Period234
Accounts Receivable For Period222325
Total Quick Assets455573
 Current Liabilities323336
Quick Ratio1.4:11.7:12.0:1
Quick Assets / Current Liabilities
Our example ratios mean that for the month we had $1.40, for the quarter we had $1.70, and for the year we had $2.00 of liquid assets for every $1.00 of current liabilities.
Current Ratio
  • What It Tells Us: Current Ratio measures a business' ability to pay its short-term liabilities with its total current assets such as cash, investments, accounts receivable, prepaid expenses, and inventories.
  • Calculation: Current Assets (cash, accounts receivables, investments, prepaid expenses, inventories) divided by Current Liabilities
  • Formula: Current Ratio =  Current Assets / Current Liabilities
  • How Normally Expressed: Ratio
  • Bad or Good: As a rule of thumb,  a current ratio below 1:1 (1.0) could indicate that a company might struggle to pay its short-term obligations; whereas ratios of 2:1 (2.0) or greater would generally indicate ample liquidity. The greater the ratio, the smaller the risk to creditors. You should use your financial information to spot trends and compare to industry averages if available.
  • Additional Clarification: A ratio of 2:1 (2.0) means that you have $2.00 of current assets for every $1.00 of current liabilities.
Example:
Current Ratio
Information: Dollars in thousandsMonthQuarter Year
Current Assets For Period


Cash212934
Marketable Securities234
Accounts Receivable222325
Prepaid Expenses431
Inventory141621
Current Assets For Period637485
Current Liabilities For Period323336
Current Ratio2.0:12.2:12.4:1
Current Assets / Current Liabilities
Our example ratios mean that for the month we had $2.00, for the quarter we had $2.20, and for the year we had $2.40 of current assets for every $1.00 of current liabilities.
Working Capital
Note: While technicaly not a ratio (subtracting instead of dividing), it is a good indicator of liquidity.
  • What It Tells Us: Working Capital assesses a business's ability to pay it current liabilities using its current assets.
  • Calculation: Current Assets (cash, accounts receivables, investments, prepaid expenses, inventories) minus Current Liabilities
  • Formula: Working Capital = Currents Assets - Current Liabilities
  • How Normally Expressed: Dollars
  • Bad or Good: Within reason, the larger the dollar amount the better. You should use your financial information to spot trends and compare to industry averages if available.
  • Additional Clarification: The ratio tells us how much cash we would have if we liquidated our current assets and paid our current liabilities.
Example:
Working Capital
Information: Dollars in thousandsMonthQuarter Year
Current Assets For Period637485
Current Liabilities For Period323336
Working Capital314149
Current Assets - Current Liabilities
Our example ratios mean that for the month we had $31,000, for the quarter we had $41,000, and for the year we had $49,000 more of current assets than current liabilities.
Bad or Good ? In general, a higher liquidity ratio shows a company is more liquid and has a better ability to pay it's outstanding debts.



Now, let's check out Solvency Ratios
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