FR - Liquidity Ratios

Written by Administrator

Monday, 30 June 2008 00:00

Ratios are a way to evaluate the performance of your business and identify potential problems. Each ratio informs you about factors such as the earning power, solvency, efficiency, and debt load of your business. They are used to measure the relationship between 2 or more components of the financial statements and have greater meaning when the results are compared to industry standards for businesses of similar size and activity. Liquidity ratios: determine the capacity of the business to meet current obligations            · Current ratio              · Inventory to net working capital              · Quick ratio Current ratio Calculation: current assets / current liabilities Also called the Working Capital Ratio, it measures the extent to which current assets are available to meet current liabilities (due within the next 12 months). The Current Ratio indicates whether the business has ample working capital i.e. the excess of current liabilities over current assets used to meet short-term obligations, quickly take advantage of opportunities, and qualify for favourable credit terms. Example: Current ratio : 3.50 A Current Ratio of 1.0 or greater is considered acceptable for most businesses. Most analysts agree that other factors need to be considered before drawing conclusions from the Current Ratio such as how quickly current assets can be converted into cash, and the credit terms extended by suppliers and to customers. A high ratio (greater than 2.0) indicates excessive current assets in the form of inventory, and underemployed capital. A low ratio (less than 1.0) indicates difficulty to meet short-term financial obligations, and the inability to take advantage of opportunities requiring quick cash Inventory to net working capital Calculation: inventory / (current assets - current liabilities) Indicates if too high a proportion of current working capital is in inventory. Because inventory is a less liquid resource than cash, too high a level of inventory can indicate the inability to turn working capital into cash to meet short-term obligations. Example: Inventory to net working capital : 2.69 % Indicates what percentage of Net Working Capital is in inventory. This result may be considered positive or negative, depending on the industry standard for companies of similar size and activity. A negative value is a sign that the company may have difficulties meeting short term financial obligations Quick ratio Calculation: quick assets / current liabilities Also called the Acid Test Ratio or the Cash Ratio, it indicates the company's ability to pay off the immediate demands of creditors using its most liquid and current assets; these can be converted quickly into cash, temporary investments, and marketable securities. It gives a more realistic picture of a business's ability to repay current obligations than the Current Ratio as it excludes inventories and prepaid items for which cash cannot be obtained immediately. This ratio is usually used as a supplement to the Current Ratio. Example: Quick ratio : 1.83 Indicates the number dollars of quick assets available to pay each dollar of current liabilities. Generally, a Quick Ratio of 1.0 or greater is considered adequate to ensure a company's ability to pay its current obligations. A value of less than 1.0 signals a problem in meeting short-term obligations

Last Updated ( Tuesday, 29 July 2008 06:13 )