In the last post we covered Activity ratios. In this post we move on to another important set of ratios – Liquidity ratios. So what are liquidity ratios? Liquidity ratios assess the liquidity position of a firm. They are a financial analysis tool to analyze a firm’s ability to meet its short term obligations. A liquidity ratio measures how quickly short term assets can be converted into cash.
Liquidity ratios mostly comprise of balance sheet items in the numerator and denominator. Listed below are some of the liquidity ratios commonly employed to analyze a firm’s liquidity position. So let us see below what is liquidity ratio and how it helps analyze the liquidity of a firm;
Current ratio is given as;
Current ratio = current assets / current liabilities
Current ratio is a liquidity ratio that measures how well the current assets cover the current liabilities. A ratio of more than 1 is most preferred. If the ratio is equal to 1 it means the current assets are equal to current liabilities and just about cover them. When the ratio is less than 1 it means the working capital (current assets – current liabilities) is negative i.e. the short term assets are not sufficient to cover the short term liabilities and probably the firm is resorting to borrowing funds to meet them.
Quick ratio is given as;
Quick ratio = cash + marketable securities + receivables / current liabilities
As you can see, the quick ratio is more stringent liquidity ratio than the current ratio. The quick ratio ignores less liquid current assets such as inventories and includes only the highly liquid ones which can be easily liquidated to meet the current liabilities. Thus the quick ratio gives a truer picture of a firm’s liquidity position than the current ratio. Therefore the quick ratio is also known as the acid test ratio. The higher the ratio the better it is.
The cash ratio is the most stringent of liquidity ratios and is given as;
Cash ratio = cash + marketable securities / current liabilities
It gives the truest picture of a firm’s ability to pay its bills on time – even in a crisis situation. Needless to say again, the higher this liquidity ratio the better it is.
‘Defensive interval’ liquidity ratio
‘Defensive interval’ liquidity ratio formula is given as;
Defensive interval ratio =cash + mktble securities + receivables /curr. liabilities
Defensive interval ratio measures the number of days for which the current liquid assets of the firm can meet its expenses. A defensive interval liquidity ratio of 30 would mean the firm’s liquid assets can cover its short term liabilities for 30 days without needing any additional funding.
‘Cash conversion cycle’ liquidity ratio
Cash conversion cycle is the last of the liquidity ratios covered here and it measures the time elapsed between investing in inventory through credit purchases to selling the finished goods on credit to settling on the accounts payable to collecting on the credit sales. The ‘cash conversion cycle’ liquidity ratio formula is given as;
Days of inventory on hand + days of sales outstanding – days of payables
A shorter cash conversion cycle indicates more liquidity as the firm needs to finance its purchases and accounts receivables only for a short period of time. A longer cycle indicates less liquidity.
That’s all in this post on Liquidity ratios…..hope you found it informative…in the next few posts we will move on to Solvency ratios, profitability ratios and then DuPont analysis of ROE ratio…so do stay tuned in as there are lots of new learning coming up for you….see you then..
For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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