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 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 |
- No of times Liquid Current assets is over Current Liabilities
- Industry implications
- Linked to cash flow cycle
- Trend is important
- Better working capital management makes ratio fall
- Seasonal factors are relevant
- Too high indicates poor working capital management
- 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 |
-
- No of times Liquid Current assets is over Current Liabilities
- Industry implications
- Linked to cash flow cycle
- Trend is important
- Better working capital management makes ratio fall
- Seasonal factors are relevant
- Too high indicates poor working capital management
- Higher quick ratios are needed when a company has difficulty borrowing on short term notice
|
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on Wednesday, October 24th, 2007 at 3:00 am and is filed under Analyze & Interpret A/cs.
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