Liquidity means the firm’s ability to satisfy its short-term obligations as they come due.
One of the common financial ratio is the
The CURRENT Ratio.
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FORMULA |
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Current Assets /Current Liabilities |
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MEASURE WHAT |
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Measure the ability of the company to meet short term obligations namely paying the current liabilities like accounts payable and others. A test of solvency / a test of short-term financial strength |
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SCORE OR VALUE |
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Normally, the higher the ratio, the better it is 2:1 : means that every $1 of current liabilities owed by the business, there is available $2 in current assets to meet or repay such liabilities. Normally, 2:1 is a norm but this varies with the different type of industries. 1:1 below average <1:1 : unsatisfactory |
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SALIENT POINTS TO NOTE: |
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1. This ratio varies with different type of industries. Hence, in some industries, 1.5:1 ratio might still be above average not necessarily 2:1 |
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2. Closely link to the cash operating cycle of business. As this ratio is all about current assets and liabilities it is actually the component in the working capital cycle of a business. Hence, tracing the trend is very important to understand whether the company is doing well in its management of its working capital cycle. A better working capital management makes the ratio to fall with less fund tied up in current assets like accounts receivables. Too high a current asset ratio like say 3:1 will means that the company is having a poor working capital management |
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3.Be awared that seasonal factors can affects this ratio for example at certain period of time, accounts receivable or inventory level might be at a lowest level in a particular type of industries. |