Liquidity Ratios

Question 1

Current Ratio

Answer 1

​
Current Ratio = Current assets / Current liabilities
​
- Measures a company’s ability to pay short-term obligations or those due within one year.

• Helps investors understand more about a company’s ability to cover its short-term debt with its current assets and make apples-to-apples comparisons with its competitors and peers.
• As a general rule, a current ratio below 1.00 could indicate that a company might struggle to meet its short-term obligations, whereas ratios of 1.50 or greater would generally indicate ample liquidity. Publicly-listed companies in the U.S. reported a median current ratio of 1.69 in 2019.

Question 2

Quick Ratio

Answer 2

QR = (CE + MS + AR) / CL
      OR
QR = (CA - I - PE) / CL
where:
QR=Quick ratio
CE=Cash & equivalents
MS=Marketable securities
AR=Accounts receivable
CL=Current Liabilities
CA=Current Assets
I=Inventory
PE=Prepaid expenses
​	
- Measures a company's capacity to pay its current liabilities without needing to sell its inventory or obtain additional financing.

• Considered a more conservative measure than the current ratio, which includes all current assets as coverage for current liabilities.
• A good quick ratio is any number greater than 1.0. If your business has a quick ratio of 1.0 or greater, that typically means your business is healthy and can pay its liabilities.

Question 3

Cash Ratio

Answer 3

Cash ratio = Cash & cash equivalents / Current liabilities
​
- Is most commonly used as a measure of a company’s liquidity.

• Is a liquidity measure that shows a company’s ability to cover its short-term obligations using only cash and cash equivalents.
• There is no ideal figure, but a ratio of at least 0.5 to 1 is usually preferred.
• If a company’s cash ratio is less than 1, there are more current liabilities than cash and cash equivalents. It means insufficient cash on hand exists to pay off short-term debt. This may not be bad news if the company has conditions that skew its balance sheets, such as lengthier-than-normal credit terms with its suppliers, efficiently-managed inventory, and very little credit extended to its customers.

Question 4

Cash Conversion Cycle (CCC)

Answer 4

​	  
CCC=DIO+DSO−DPO
where:
DIO=Days of inventory outstanding
(also known as days sales of inventory)
DSO=Days sales outstanding
DPO=Days payables outstanding
​	
- Is a metric that expresses the length of time (in days) that it takes for a company to convert its investments in inventory and other resources into cash flows from sales.

• This metric takes into account the time needed to sell its inventory, the time required to collect receivables, and the time the company is allowed to pay its bills without incurring any penalties.
• A good cash conversion cycle is a short one. If your CCC is a low or (better yet) a negative number, that means your working capital is not tied up for long, and your business has greater liquidity.

Question 5

Operating Cash Flow Ratio

Answer 5

Operating cash flow ratio = Operating cash flow / Current liabilities
​
- Indicates if a company’s normal operations are sufficient to cover its near-term obligations.

• A higher ratio means that a company has generated more cash in a period than what was immediately needed to pay off current liabilities.
• A higher ratio – greater than 1.0 – is preferred by investors, creditors, and analysts, as it means a company can cover its current short-term liabilities and still have earnings left over. Companies with a high or uptrending operating cash flow are generally considered to be in good financial health.

Question 6

Receivables Turnover Ratio

Answer 6

Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable

In comparison to industry average:

• A high receivables turnover ratio may indicate that a company’s collection of accounts receivable is efficient and that the company has a high proportion of quality customers that pay their debts quickly.
• A low receivables turnover ratio could be the result of inefficient collection, inadequate credit policies, or customers who are not financially viable or creditworthy.

Question 7

Inventory Turnover

Answer 7

Inventory Turnover = COGS / Average Value of Inventory
where:
COGS=Cost of goods sold
​ and:
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
then:
365 / inventory turnover

Measures how many times in a given period a company is able to replace the inventories that it has sold.

A good inventory turnover ratio is between 5 and 10 for most industries, which indicates that you sell and restock your inventory every 1-2 months. This ratio strikes a good balance between having enough inventory on hand and not having to reorder too frequently.

Question 8

Working Capital Turnover

Answer 8

Working Capital Turnover = Net Annual Sales / Average Working Capital
where:
- net annual sales is the sum of a company’s gross sales minus its returns, allowances, and discounts over the course of a year
- average working capital is average current assets less average current liabilities

• Measures how effective a business is at generating sales for every dollar of working capital put to use.
• A higher working capital turnover ratio is better, and indicates that a company is able to generate a larger amount of sales.
• A working capital ratio of less than one is taken as indicative of potential future liquidity problems, while a ratio of 1.5 to two is interpreted as indicating a company on solid financial ground in terms of liquidity.