Liquidity means the firm’s ability to satisfy its short-term obligations as they come due.
In my earlier article, we have discussed the Current Asset Ratio. Another common financial ratio to measure the liquidity of the company is :
The QUICK (ACID-TEST) RATIO:
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FORMULA |
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Current Assets minus Inventories/Current Liabilities |
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MEASURE WHAT |
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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. |
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SCORE OR VALUE |
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>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 |
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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, 0.8:1 ratio might still be above average not necessarily 1:1 |
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2. Closely link to the cash operating cycle of business. As this ratio is all about current assets (minus inventories which is not easily saleable) 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. |
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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. |
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4. Higher quick ratios are needed when a company has difficulty borrowing on short term notice |